How to use PEG

Company Simpson:

Recent PE 17.6 based on:

• a share price of $33 and
• TTM earnings of 1.87.

Earnings yields would thus be 1/17.6, or 5.7%.

What is the significance?

This investment could be compared to a long-term Treasury security as a prospective investment.

Treasury security: today yielding about 4.5%.

Which investment is better?

An investment in Simpson returns more, and, although riskier, it affords the opportunity for gain through growth.


The difference in earnings yield illustrates the basic risk/return tradeoff between investing in corporate equities versus safe fixed-income Treasuries.

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You still don't know whether Simpson's PE ratio of 17.6 is attractive or compelling.

Long-time tech high-flyer Cisco Systems is at PE ratio to 27.4.

While banking stalwart Bank of America is at PE ratio of 10.


Why the difference?

The primary reason is growth.

Investors pay higher PEs for companies with greater growth prospects.

Greater prospects mean greater earnings and greater earnings yields sooner.

So when comparing businesses, one popular way to "normalize" PEs is to compare them to their respective company's growth rate.

From this comparison, you get a ratio known as PE to growth, or PEG:

Price/Earnings to growth (PEG) = (PE)/(EPSGR)

If the earnings growth rate of :

• Cisco is 25%, while
• Simpson's is 10% and
• Bank of America's is 5%,

then their respective PEG is:

• 27.4/25 or 1.1 for Cisco,
• 17.6/10 or 1.76 for Simpson, and
• 10/5 or 2 for Bank of America.

Now if you are confident in the sustainability of the growth rates, you'd pick Cisco as the best investment, because its PE is modest compared to its growth rate.

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So, the lower the PEG, the better.

But if the low PEG is driven by high growth rates, you'd better be confident in the growth rate assumption.

Nothing falls faster than a growth stock that suddenly stops growing.

For years, Starbucks had been a high PE and high growth story, with PE ratios exceeding 30 and growth rates exceeding 20%. When the growth rate slowed just a bit in early 2007, the stock lost a third of its value.


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Projecting growth rates can be tricky, and for that reason, value investors tend to shy away from stocks where growth appears temporary or hard to justify long term.

What rate should you use?
What the company has already achieved?
What the analysts project it to do?
Over what period?
When will the growth rate run into the law-of-large numbers-wall?
What growth rate did those Krispy Kreme Investors use in the 2000 - 2004 period?

Most of them ended up with a sticky mess.

The big question , of course, in picking Cisco as the "best investment," is the sustainability of the growth rate.

Simpson, while trailing a bit, may be a safer and better long-term investment.

Summary: It is okay to assume a high growth rate, so long as it is sustainable growth, based on sustainable business and marketplace fundamentals.