Earnings Growth, Earnings Yield and PEG

PEG relates, or normalizes, the PE to the growth rate.

• With PEG, apparently high PE ratios are supported by forward growth.
• PEG thus becomes a better tool to compare stocks with different PEs and different underlying growth assumptions.

By itself, it's hard to tell whether a PE is good or bad.

A stock with a PE of 30 may be a better deal than another stock with a PE of 15. Why? Because of growth.

• A stock of a no-growth company with a PE of 15 will never achieve an earnings yield beyond 7.5% (1/15).
• Meanwhile, the company with a PE of 30, with a growth rate of 20%, eventually achieves an earnings yield greater than 20%.

Enter the practice of normalizing PE by the growth rate.

• To do that, we divide all PEs by the company's growth rate to create a ratio known as (Price/earnings)/growth, or PEG for short.
• G is the growth rate, expressed as a whole number (that is, the percentage times 100).
• So, a company with a PE of 30 and a growth rate of 20% has a PEG of 1.5.

This gives a standard for comparison.

• Company A with a PE of 18 and a growth rate of 12% has the same PEG as Company B with a PE of 30 and a growth rate of 20%.
• Are the two PEs the same? 30 versus 18?
• Clearly not - until the underlying growth fundamentals are identified, apply PEG, and find out they are indeed priced equally.

The table below shows the relationship between future earnings yield, PE, and PEG. Watch what happens to PEG and future earnings yields as growth assumptions rise.

http://spreadsheets.google.com/ccc?key=toPlORpn7n23_xeRq2vYALQ

Low PEG ratios (less than 2) correspond to high future earnings yields.

You can see:

PEG = 2 scenario corresponds to a future earnings yield of 13%.
PEG = 1.30 correlates to 20%, and,
PEG = 1 correlates to a future earnings yield of 31% on today's investment price.

On the other hand, if:

PEG = 4, the implied future earnings yield is only 8.1%.

So, what is a "good" PEG ratio?

It all depends on the implied future rate of return you're looking for, which depends on

• (1) investment objectives,
• (2) risk tolerance, and
• (3) current risk-free (bond) interest rates.

A PEG of 2.7 or less: implies a future earnings yield of 10% or more.

A PEG of 2.7 or more: implies a future earnings yield of 10% or less. This is probably less return at more risk than most investors desire.

As a guide:

A PEG of 1 or less: this is great (but hard to find)

A PEG between 1 and 2: this is good.

A PEG between 2 and 3: this is marginal.

A PEG over 3: should probably be avoided.