PEG Ratios

Investment Strategies that compare PE to the expected growth rate

Problems with comparing PE ratios to expected growth

PE Ratio versus Growth - The Effect of Interest rates:

Average Risk firm with 25% growth for 5 years; 8% thereafter

PE Ratios Less Than The Expected Growth Rate

PEG Ratio: Definition

PEG = PE / Expected Growth Rate in Earnings

PE/Expected Growth Rates Across the Market

PEG Ratios: A Quick Test

PEG Ratio: Reading the Numbers

The average PEG ratio for the software sector is 1.77. The lowest PEG ratio in the group belongs to BancTec, which has a PEG ratio of 0.76. Using this measure of value, BancTec is

PEG Ratio: Analysis

PEG Ratios and Fundamentals

A Simple Example

Variable High Growth Phase Stable Growth Phase

Expected Growth Rate 25% 8%

Payout Ratio 20% 50%

Beta 1.00 1.00

PEG Ratios and Risk

PEG Ratios and Quality of Growth

PEG Ratios and Expected Growth

PEG Ratios and Fundamentals: Propositions

Proposition 1: High risk companies will trade at much lower PEG ratios than low risk companies with the same expected growth rate.

Proposition 2: Companies that can attain growth more efficiently by investing less in better return projects will have higher PEG ratios than companies that grow at the same rate less efficiently.

Proposition 3: Companies with very low or very high growth rates will tend to have higher PEG ratios than firms with average growth rates. This bias is worse for low growth stocks.

PE/growth: Returning to the Software Sector

Analyzing PE/Growth

Given that the PEG ratio is still determined by the expected growth rates, risk and cash flow patterns, it is necessary that we control for differences in these variables.

PEG = 3.04 - 2.17 (Expected Growth) - 2.19 (Std Deviation in Prices)

Estimating the PEG Ratio for Adobe Systems

Applying this regression to Adobe Systems, the predicted PEG ratio for the firm can be estimated using Adobeís measures for the independent variables:

Expected PEG Ratio for Adobe = 3.04 - 2.17 (.195) - 2.19(Std Dev) = 1.83

Extending the Comparables

This analysis, which is restricted to firms in the software sector, can be expanded to include all firms in the firm, as long as we control for differences in risk, growth and payout.

PEG = a + b (Growth Rate) + c (Risk) + d (Payout Ratio)

Market Regressions: PEG Ratio

PE, PEG Ratios and Risk: September 1997