The Folly of PEG Ratio

Price Earning Growth (PEG) Ratio is the ratio of a company's P/E with its growing rate. A batch of analysts have got concurred that a stock is fairly valued when its peg ratio equal one. This agency that if a stock have got a P/E of 10 with a growing rate of 10%, then the stock is trading at just value.

How many of you have seen this sort of statement? I have got seen it plenty of modern times and I believe it is silly. This is a relatively simple reasoning. Let's think of it for a second. If a stock will turn its earning for 8%, then to attain just value, the stock have to merchandise at a P/E of 8. How about a stock with growing rate of 5%? Its just value is a P/E Of 5. How about a company with 0% growth? Oh, right. According to this theory, the company should have got a P/E of 0, or worthless. Bashes this brand sense? Heck, no. But there are a batch of articles regarding this peg theory. Here are respective beginnings of commonly misunderstood 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% growing company, the just P/E ratio for the company is not 0. Rather, it is a few percentage above risk-free interest rate or a 10 twelvemonth exchequer bond. If a 10 twelvemonth chemical bond is yielding 4.6%, then the just 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 incorrect with using peg ratio to determine the just value of a common stock? peg presumes infinite growing rate in earning per share. No company can turn at the same rate forever. If we presume company A volition turn at 10% rate for the adjacent five old age and then growing slows to 2% indefinitely, what is the just value of the common stock using peg ratio? The reply is it can't make that. peg ratio is manner too simple to single-handedly delegate a just value for a common stock. It is misleading and simply incorrect to utilize peg ratio for our just value calculation.

Common sense orders that a stock with higher growing rate should be valued at a higher P/E ratio. There is nil incorrect with that. But using a simple peg ratio of one as a just value of a common stock is simply wrong. I don't have got an accurate manner to cipher this but an estimate can be read on other articles entitled Calculating Carnival Value with Growth and Carnival Value with Negative Growth.