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Price Earning Growth (PEG) Ratio is the ratio of a company's P/E
with its growth rate. A lot of analysts have concurred that a
stock is fairly valued when its PEG ratio equal one. This means
that if a stock has a P/E of 10 with a growth rate of 10%, then
the stock is trading at fair value.
How many of you have seen this kind of statement? I have seen it
plenty of times and I think it is silly. This is a relatively
simple reasoning. Let's think of it for a second. If a stock
will grow its earning for 8%, then to reach fair value, the
stock has to trade at a P/E of 8. How about a stock with growth
rate of 5%? Its fair value is a P/E Of 5. How about a company
with 0% growth? Oh, right. According to this theory, the company
should have a P/E of 0, or worthless. Does this make sense?
Heck, no. But there are a lot of articles regarding this PEG
theory. Here are several sources of commonly misunderstood |
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PEG
ratio:
http://www.moneychimp.com/glossary/peg_ratio.htm
http://www.fool.com/School/TheFoolRatio.htm
http://www.investopedia.com/articles/analyst/043002.asp
For a 0% growth company, the fair P/E ratio for the company is
not 0. Rather, it is a few percentage above risk-free interest
rate or a ten year treasury bond. If a ten year bond is yielding
4.6%, then the fair value of a common stock is at 7.6% yield.
Inverting this yield, we get a P/E ratio of 13.2.
Anything else is wrong with using PEG ratio to determine the
fair value of a common stock? PEG assumes infinite growth rate
in earning per share. No company can grow at the same rate
forever. If we assume company A will grow at 10% rate for the
next five years |
