Good investors want to find companies whose share prices are at meaningful discounts to their underlying value. Warren Buffett best captured this concept with his timeless quote, “Price is what you pay, value is what you get.” The idea behind this quote is that price does not necessarily equal value.
Doing valuation right is key to smarter investing. Please excuse our English here: while there are many ways to do valuation right, there are many ways to do it wrong. We recently wrote about one way to do it wrong in “Avoid This Common Investing Mistake to Improve Your Results,” which described how comparing a company’s current valuation multiple to its five-year average can lead to the belief that your stock is cheap.
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Another way to do it wrong is to use PEG ratios. This ratio compares a stock’s P/E multiple (“PE”) to its long-term earnings growth rate (“G”). Amazon (AMZN) has a P/E multiple of 41x, with Wall Street analysts projecting that earnings will grow at a 29% pace over the next four years. The resulting ratio of 1.4x (or 41 ÷ 29) is the PEG ratio.
The concept is simple enough. How much are you paying for growth? It usually makes sense to pay more to get faster growth. This ratio attempts to make valuation comparisons between companies with different growth rates more useful. Amazon is more expensive at 41x earnings than Verizon (VZ) at 8x earnings, but Verizon’s sluggish growth at just over 1%, which produces a PEG ratio of nearly 6x, makes Amazon look like a bargain.
This ratio was popularized by Peter Lynch, the former veteran manager of the Fidelity Magellan mutual fund whose long-running outperformance is legendary. Lynch said that “the P/E ratio of any company that’s fairly priced will equal its growth rate.” This launched the PEG ratio into widespread use, along with the idea that a PEG ratio of 1.0x represents fair value.
But Lynch no doubt didn’t blindly use this ratio as the sole indicator of value. He had an immense skill and knowledge base, along with an army of analysts, to help evaluate all aspects of a company’s business model, growth rate and valuation. The PEG ratio may have been a convenient rule of thumb for his style and era, but its sole use can produce wildly wrong valuations.
The Flaws of the PEG Ratio
One flaw is that it can lead to nonsensical conclusions. Previously mentioned Verizon is likely to produce about 1% earnings growth, but who would say that its valuation should be only 1x earnings? Packaged food company Conagra (CAG) is expected to grow earnings at a 3% pace but trades at 10x earnings, making it appear wildly expensive with a 3.3x PEG ratio. But few would argue that a company with stable profits and cash flows, capable leadership and a reasonably sturdy balance sheet should trade at 3x earnings.
On the other end, apparel maker VF Corp (VFC) trades at a PEG ratio of 0.41x, based on its 9x multiple and 22% expected growth rate. But are the shares really a bargain? Unlikely, as the company is struggling with stale brands and excessive debt.
The ratio doesn’t work for a wide swath of sectors. Companies in the financials, energy, basic materials, real estate and utilities sectors have profit and growth traits that render the PEG ratio meaningless. JPMorgan (JPM), for example, trades at a 15.4x multiple but is expected to have negative (-4%) earnings growth. Should it trade at a negative multiple? Bank of America (BAC) has a similarly meaningless ratio. And, fast-growing financial service firms tend to blow up eventually, so paying up for their fast growth can lead to dismal results.
Material companies have inherently cyclical earnings which also tend to be unpredictable, so their estimated growth rates are meaningless. Utilities almost universally have modest 5-6% growth rates, but generally trade at multiples of 14-16x. Much of their valuation is driven by their reliable dividends, which currently produce yields of 4-5%. Are they hugely overvalued with PEG ratios of 2.5x?
Another flaw is that the ratio assumes that all growth has the same value. But this isn’t necessarily true. Companies can spend aggressively to generate earnings growth at the expense of shareholder value. The growth may make the shares appear to be a PEG bargain when they clearly are not. On the other hand, fast growth could be undervalued. Earnings growth at a successful company may be producing exceptional shareholder value, so investors relying on a PEG ratio may perceive a stock as being expensive when it actually is a bargain.
Investors considering using PEG ratios will want to be wary of other problems. Growth estimates for a company can change with one good or bad quarterly result, as Wall Street analysts extrapolate near-term results well into the future. The PEG ratio assumes that fast-growing companies can sustain that pace indefinitely (or for at least the next five years), but these companies usually can’t. Pandemic-era fast-growers like Zoom Video Communications (ZM) were converted into sharply negative growers, with awful results for investors who thought they were getting a PEG bargain.
Investors would be best served by ignoring the flawed PEG ratio.
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