Chapter 4: The Mighty PEG
There are many methods you can use to pick a share, and everyone will have their own preferences. Some will seek out high dividends, some will follow the news, others read up on the broker’s recommendations and many study the charts (mostly price, not astrological!). While all of these and other selection techniques have merit, when it comes to stock selection I believe the PEG is the king!
What is the PEG?
In the previous chapter we looked at the PE ratio. We saw that while it was a useful measure, it does have limitations. For example, if company A has a PE of 12x and company B has a PE of 10x, then we can say that company A is more expensive (or has a higher rating) than company B. But that is all. The PE cannot tell us whether company A actually deserves its higher PE because its earnings are forecast to grow faster than those of company B. This is where the PEG comes in.
The PEG adds the factor of the forecast earnings growth to the PE calculation.
The formula to calculate the PEG is:
PEG ratio = PE ratio/orecast earnings growth
The PEG acronym stands for price earnings growth, and its great strength is that it combines in one measure three key elements that investors need to assess a stock: price, earnings, and forecast earnings.
The value of the PEG
In the long run, successful share investors are those who invest in companies whose shares are priced cheaply in relation to their current and future earnings. The PEG is a simple value measure that will enable you to find such shares and one which cuts across all normal market sectors and borders. It therefore provides you with a method of comparing not only similar companies (i.e. in the same sector), but all companies.
Successful investors should be looking to factor in future growth into his or her calculations, and this is what the PEG will do. In essence, therefore, the PE will highlight shares that are cheap, while the PEG will highlight shares that are undervalued. There is a big difference.
The GARP theory
The legendary Jim Slater popularised the PEG ratio, but it was Peter Lynch who introduced the GARP (Growth At a Reasonable Price ) theory – the idea underlying the PEG. In his book One Up on Wall Street he wrote:
“The PE ratio of any company that is fairly priced will equal its growth rate.”
To me this makes perfect sense, and as a rule of thumb it is something I always bear in mind when evaluating possible share purchases.
The GARP theory suggests that if a company’s share price is at its fair value then it will have a PEG of one. A PEG of less than one would indicate that the shares are undervalued; a PEG of over one that the shares are overvalued.
I love simple ideas that make sense and work most of the time. The GARP theory certainly ticks all three boxes for me!
Using the PEG
As I have already said I find one of the great benefits of using the PEG ratio is that it provides a means to make a value comparison on very different companies: those in different situations and different sectors.
For example, a company that is boring and cheap with a PE of eight and forecast growth of 8% has a PEG of one (8/8). Whereas a company that may be exciting but expensive with a PE of 30 and forecast growth of 30% also has a PEG of one. Just being cheaper (i.e. having a lower PE) does not necessarily make the first company a better buy.
I suggest that you let the PEG determine which stocks are the better value. The lower the PEG, the better the value.
Example
As an aid to stock selection, in most situations I find the PEG has no equal and the more I have used it the better investor I have become. I find it does not just inform my selections but can also help time my exits.
Take ASOS [ASC], a share I have written about before as an example. In the winter 2007 edition of Smart Investor, the Barclays Stockbrokers client magazine, I made this one of my two shares to follow. One of the main reasons for this was the PEG ratio, which at the time was 0.8 (when the share price was 110p). As the price quadrupled, the PEG also improved from 0.8 to 0.6. The PEG was saying that ASOS was a better buy at 500p than it had been at 110p!
How is that possible?
Well, simply because the forecast earnings growth had increased more than the price.
As you can see from the following chart, the share price in 2008 and 2009 rose steadily; but this price rise was outpaced by the forecast earnings growth as evidenced by the falling PEG. Moving into 2010, the share price rose at a faster pace and this accelerated trend eventually brought the falling PEG to a halt. When the share price rose almost vertically, the PEG also eventually began to rise.
Figure 4.1: ASOS
The share price eventually rose to over £18. For the investor, a PEG of over 2 was saying: time to think about taking some profits. ASOS was, and is still, a good company, but at that price the PEG was saying it was no longer undervalued. Used in this way, a PEG therefore does not just inform selection but can also time your exits or partial withdrawals from a stock.
The whole balance between price, current earnings and earnings growth can be a delicate one and, of course, you are dealing with a dynamic situation. It’s possible that an increase in future earnings could once again reverse the rise in the PEG. However, as a simple rule of thumb, using the PEG in this manner to time stock entrances and exits works for me.
Trading and the PEG
If you were trend trading this share, the position in my opinion would be different. Although the low PEG may have played a part in selection of the trade, the key point of focus for a trader is momentum. Although the rising PEG ratio may put the trend trader on alert to exit, he should stick with the trade while the positive momentum remains. Therefore, for the trader, the 30-day and 90-day moving averages should be the method used to time the exit [I will go into this in some more detail in a later chapter].
It may seem strange to some that the method and timing of the exit may be different for the trader and investor. After all, it is the same share owned at the same time. However, as the legendary Benjamin Graham once said when discussing speculation:
“It is perfectly proper to take speculative factors into account, which are different from investment factors.”
There is no bigger factor for the trader to take into account than short-term momentum, so the trader should stay with the share until this reverses or at least subsides.
PEG limitations
Like everything in life the PEG has its limitations:
- The PEG can not be calculated for companies that have no earnings growth or are not making a profit at all. Although there is always a place for the “jam tomorrow” investments in a portfolio, perhaps this is a reminder to us that the number of such companies in a portfolio should be kept to a minimum.
- The PEG tends to under-rate mature companies with high stable profits that you may find attractive for different reasons (such as a high dividend).
- If you are using the one-year forecast PEG (which is the one I would recommend) you do have to remember it is a forecast and forecasts are not always accurate.
- When calculating the PEG you should factor into your decision-making process the size of the company. For example, it may be easier to forecast earnings growth for a larger, established company with earnings around £100m than it is for an upstart with earnings under £1m. The larger the company and the profit the more robust and reliable the forecasts tend to be.
Where to find PEG data
You will find the PEG is one of the most common measures and is widely quoted.
For example, they are on the Barclays Stockbroker website on the summary page for each company, and also under the financial tab (see the following screenshot):
Figure 4.2: screenshot of Barclays Stockbroker web page
The stock filters on websites can also help you use the PEG to its full potential. The best filter on the Barclays Stockbroker website is found under the “stock selector” in the stock tools section. Go to the “build your own” section then to the full screener option. Under this you have scores of different options you can select to use in conjunction with each other.
The one I frequently use is under the sub heading “valuation ratios”: the “next year forecast PEG”. I would follow Peter Lynch’s advice; in the minimum box insert 0.0 and in the maximum 0.9. According to the GARP theory, the shares it will identify will represent the most undervalued growth stocks on the London markets. This is a good shortlist to start with, and if you want to make it shorter just make the criteria stricter.
Along with the preceeding PEG requirements, I often insert a minimum forecast dividend of 3% with minimum cover of two. I think the combination of the potential growth, highlighted by the PEG, and the relatively high forecast income make an interesting cocktail…try mixing one yourself!
Note: a table of PEG values at the time of writing for the FTSE100 companies can be found in the appendix.