Using the PEG Ratio for Comparisons

 

Using the PEG Ratio for Comparisons

 

As with the PE ratio, the PEG ratio is used to compare the valuations of firms that are in the same business. The PEG ratio is a function of

• the risk,
• growth potential and
• the payout ratio of a firm.

In this section, you look at ways of using the PEG ratio and examine some of the problems in comparing PEG ratios across firms.

Direct Comparisons

PEG Ratios and Retention Ratios

Most analysts who use PEG ratios compute them for firms within a business (or comparable firm group) and compare these ratios.

Firms with lower PEG ratios are usually viewed as undervalued, even if growth rates are different across the firms being compared.

This approach is based upon the incorrect perception that PEG ratios control for differences in growth. In fact, direct comparisons of PEG ratios work only if firms are similar in terms of growth potential, risk and payout ratios (or returns on equity). If this were the case, however, you could just as easily compare PE ratios across firms.

When PEG ratios are compared across firms with different risk, growth and payout characteristics and judgments are made about valuations based on this comparison, you will tend to find that:

· Lower growth firms will have higher PEG ratios and look more over valued than higher growth firms, because PEG ratios tend to decrease as the growth rate decreases, at least initially.
· Higher risk firms will have lower PEG ratios and look more under valued than higher risk firms, because PEG ratios tend to decrease as a firm’s risk increases.
· Firms with lower returns on equity (or lower payout ratios) will have lower PEG ratios and look more under valued than firms with higher returns on equity and higher payout ratios.

In short, firms that look under valued based upon direct comparison of the PEG ratios may in fact be firms with higher risk, higher growth or lower returns on equity that are, in fact, correctly valued.



Controlled Comparisons

When comparing PEG ratios across firms, then, it is important that you control for differences in risk, growth and payout ratios when making the comparison. While you can attempt to do this subjectively, the complicated relationship between PEG ratios and these fundamentals can pose a challenge. A far more promising route is to use the regression approach suggested for PE ratios and to relate the PEG ratios of the firms being compared to measures of risk, growth potential and the payout ratio.

As with the PE ratio, the comparable firms in this analysis can be defined narrowly (as other firms in the same business), more expansively as firms in the same sector or as all firms in the market. In running these regressions, all the caveats that were presented for the PE regression continue to apply. The independent variables continue to be correlated with each other and the relationship is both unstable and likely to be nonlinear.

A scatter plot of PEG ratios against growth rates, for all U.S. stocks in July 2000, indicates the degree of non-linearity.

In running the regression, especially when the sample contains firms with very different levels of growth, you should transform the growth rate to make the relationship more linear. A scatter plot of PEG ratios against the natural log of the expected growth rate, for
instance, yields a much more linear relationship.

http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf