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Valuation Ratios: The PEG Ratio

by Joe Lan, CFA

In the past two articles in the Financial Statement Analysis series, I provided an introduction to valuation ratios and an analysis of the dividend discount model.

In this article, I continue my discussion of valuation metrics with the ratio of price-earnings to earnings growth, known as the PEG ratio.

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Joe Lan is a financial analyst at AAII.
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The Price-Earnings Ratio

The price-earnings ratio (P/E) is one of the most basic metrics of stock valuation. It is calculated by dividing a stock’s current price by its earnings, giving a relative valuation of a company based on its level of earnings per share. It allows investors to compare stocks with very different earnings per share on equal footing.

Though the price-earnings ratio may be the most widely used valuation ratio, there are glaring weaknesses in the figure. Perhaps most importantly, the price-earnings ratio fails to directly take into account an imperative characteristic of any stock—growth (or lack thereof). However, the price-earnings ratio is considered to be a measure of the market’s opinion of the company’s future prospects, which includes growth. From a pure price-earnings valuation standpoint, a stock with a price-earnings ratio of 10 is trading at a discount relative to a stock with a price-earnings ratio of 15. Still, investing in the lower price-earnings ratio stock may not be a prudent choice if the higher price-earnings ratio stock is growing twice as fast.

Consider the situation when the company trading with a price-earnings ratio of 10 is growing at 10% per year while the company trading with a price-earnings ratio of 15 is growing at 15% per year. Choosing the better investment gets much more difficult. When evaluating firms that are growing at significantly different rates or at high absolute rates, it is more practical to employ the PEG ratio to take into account growth rates. In addition, the PEG ratio can provide you with an idea of whether a high-growth company is worth its rich price-earnings valuation.

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The PEG ratio looks at earnings growth relative to the price-earnings ratio. Many investors use the PEG ratio to better differentiate stocks and to add a growth element to the basic price-earnings ratio.

The PEG Ratio

The PEG ratio is calculated by dividing a company’s price-earnings ratio by its growth rate in earnings per share:

PEG ratio = (current price ÷ earnings per share) ÷ earnings per share growth rate

There are also many variations of the PEG ratio, which are beneficial in different situations. I discuss several of them.

Historical PEG Ratio

Perhaps the simplest PEG ratio is the historical PEG, which divides current price-earnings ratio by the historical growth rate in earnings. It is up to the investor to choose the time frame for historical growth, but generally three- to five-year periods are the norm. Table 1 uses data exported using AAII’s fundamental stock screener and research database Stock Investor Pro to calculate the historical PEG ratio of five major U.S. oil companies—ExxonMobil (XOM), Chevron Corp. (CVX), ConocoPhillips (COP), Valero Energy (VLO) and Marathon Oil (MRO). In the table, the historical PEG ratios are calculated using both three-year and five-year historical earnings growth rates. I also use these same companies in subsequent examples.

As you can see from the table, the figures vary widely, ranging from 0.2 to 2.4 for the historical PEG using three-year growth rates and 0.3 to 0.6 using five-year historical growth in earnings. Negative PEG ratios are not meaningful. PEG ratios are meaningful only if the company has a positive growth rate in earnings. The PEG ratio using a three-year earnings growth figure returned two figures that are not meaningful, while the historical PEG using five-year growth in earnings returned three that are not meaningful.

  P/E Hist Growth Hist PEG
  Ratio 3-Yr 5-Yr 3-Yr 5-Yr
  (X) (%) (%) (X) (X)
ExxonMobil (XOM)
13.8
5.8
-3.2
2.4
-4.3
Chevron Corp. (CVX)
12.2
5.4
-1.0
2.3
-12.2
ConocoPhillips (COP)
11.9
-2.2
21.1
-5.4
0.6
Valero Energy (VLO)
10.5
45.2
33.6
0.2
0.3
Marathon Oil (MRO)
16.0
-5.2
-13.9
-3.1
-1.2
Source: AAII Stock Investor Pro/Thomson Reuters. Data as of 5/9/2014.

While historical growth rates show companies’ short- and longer-term historical performance, most investors are concerned with future earnings potential instead of past growth. This leads us to the next PEG variation—the forward PEG ratio.

Forward PEG Ratio

The forward PEG ratio compares the forward price-earnings ratio (current price divided by the consensus earnings per share estimate for the current fiscal year) to the estimated growth rate in earnings per share.

The rationale behind using this ratio is simple—stocks with a high-expected growth rate should trade with higher price-earnings ratios than stocks with low expectations for future earnings growth. Once again, there are several time frames that can be used for expected growth rate. AAII’s Stock Investor Pro provides an estimated three-to-five year growth rate, but it is often difficult to forecast far into the future. At AAII, we also use another expected growth rate for some of our portfolios, one that measures the growth of earnings from the past fiscal year through the next two fiscal years. Table 2 presents the forward PEG ratios for the same five U.S. oil companies.

Similar to historical PEG ratios, forward PEG ratios also show a large variance. The forward PEG ratios using an average growth rate for the past fiscal year and the next two years (Y0 to Y2) range from 0.8 to 25.8 with one not meaningful number, while forward PEG ratios using an average earnings growth estimate for the next three to five years range from 0.6 to 3.6. Chevron’s 25.8 forward PEG ratio is an anomaly; figures this high are generally due to an abnormally low growth rate (it can also be due to an abnormally high price-earnings ratio based on low earnings, but this is less common). As you can see, Chevron is only expected to grow 0.4% over the next two years, leading to an abnormally high forward PEG ratio.

  Forward Earnings Est Growth (%) Forward PEG
  P/E Y0 Y1 Y2 Y0 to Y2 3-5 Yr Y0 to Y2 3-5 Yr
  (X) ($) ($) ($) (%) (%) (X) (X)
ExxonMobil (XOM) 13.2 7.41 7.71 7.68 1.8 3.7 7.3 3.6
Chevron Corp. (CVX) 11.6 11.10 10.75 11.20 0.4 5.5 25.8 2.1
ConocoPhillips (COP) 12.4 6.51 6.26 6.16 -2.7 7.0 -4.5 1.8
Valero Energy (VLO) 8.5 5.33 6.56 6.43 9.8 14.6 0.9 0.6
Marathon Oil (MRO) 11.9 2.26 3.01 2.97 14.6 4.4 0.8 2.7
Source: AAII Stock Investor Pro/Thomson Reuters. Data as of 5/9/2014.

Adjusting for Dividends

Often, especially in value investing, there are large and highly profitable companies that return much of their earnings to shareholders in the form of cash dividends. These companies may be growing slowly and appear to be significantly overvalued. However, in addition to earnings growth driving share prices, shareholders get a sizable dividend on a regular basis. These dividends are a form of return and the normal PEG ratios do not take into account the dividend these companies pay, placing them at a disadvantage. In these cases, an adjustment can be made to the PEG ratio to “level the playing field” between these types of stocks and non-dividend-paying stocks. The dividend-adjusted PEG ratio is calculated as follows:

Dividend-adjusted PEG ratio = price-earnings ratio ÷ (earnings growth rate + dividend yield)

Once again, there are two different dividend-adjusted PEG ratios that are often used by investors. The historical dividend-adjusted PEG uses the historical price-earnings ratio and earnings growth rate, while the forward PEG uses the forward price-earnings ratio and an estimated earnings growth rate. Table 3 presents both of these ratios for the same five oil companies.

Historical Dividend-Adjusted PEG Ratios
    Div Hist Growth Hist Div-Adj PEG
  P/E Yield 3-Yr 5-Yr 3-Yr 5-Yr
  (X) (%) (%) (%) (X) (X)
ExxonMobil (XOM) 13.8 2.7 5.8 -3.2 1.6 -27.6
Chevron Corp. (CVX) 12.2 3.4 5.4 -1.0 1.4 5.1
ConocoPhillips (COP) 11.9 3.6 -2.2 21.1 8.5 0.5
Valero Energy (VLO) 10.5 1.8 45.2 33.6 0.2 0.3
Marathon Oil (MRO) 16.0 2.1 -5.2 -13.9 -5.2 -1.4
Forward Dividend-Adjusted PEG Ratios
  Forward Div Est Growth Frwd Div-Adj PEG
  P/E Yield Y0 to Y2 3-5 Yr Y0 to Y2 3-5 Yr
  (X) (%) (%) (%) (X) (X)
ExxonMobil (XOM) 13.2 2.7 1.8 3.7 2.9 2.1
Chevron Corp. (CVX) 11.6 3.4 0.4 5.5 3.0 1.3
ConocoPhillips (COP) 12.4 3.6 -2.7 7.0 14.2 1.2
Valero Energy (VLO) 8.5 1.8 9.8 14.6 0.7 0.5
Marathon Oil (MRO) 11.9 2.1 14.6 4.4 0.7 1.8
Source: AAII Stock Investor Pro/Thomson Reuters. Data as of 5/9/2014.

For companies such as these, the dividend-adjusted PEG ratios have numerous advantages. Investors who purchase these stocks are often looking for a yield to provide current income and stability. These five companies are large and mature and are unlikely to grow at a pace much faster than that of the overall economy. Incorporating the dividend yield into valuation allows investors to take into account the varying yields of these companies when using the PEG ratio for analysis.

The historical dividend-adjusted PEG ratios using the three-year earnings growth rate range from 0.2 to 8.5, with one figure that is not meaningful; using the five-year earnings growth rate the historical dividend-adjusted PEG range is 0.3 to 5.1, with two not meaningful figures. As usual, the forward dividend-adjusted PEG ratios are less skewed, ranging from 0.7 to 14.2 based on a two-year estimated earnings growth rate and 0.5 to 2.1 based on a five-year estimated earnings growth rate.

Using the PEG Ratios

As is the case with most ratios used in investment analysis, making sense of the ratios in the real world is much more difficult than calculating them.

From an overall valuation standpoint, it looks like Valero Energy is trading with the lowest valuations based on the PEG ratios. The company has grown strongly over the last three-year and five-year time frames and is expected to grow the quickest going forward. In addition, its price-earnings ratios (historical and forward) are the lowest out of the five.

However, you will almost immediately notice that Valero Energy’s dividend yield of 1.8% is the lowest out of the five companies. Investors often purchase large oil companies because of their stability and dividend yield, and investors may be hesitant to buy a major oil stock without the type of yield they expect. In addition, Valero’s expected three- to five-year earnings growth rate is significantly higher than any other oil company, leading to its much lower forward dividend-adjusted PEG ratio. A prudent investor would ask whether such a high growth rate in the intermediate future is appropriate given the tempered expectations of the rest of the companies.

Caveats

The PEG ratio has often been used to value companies with high levels of growth (though our examples used slower-growing companies). One of the reasons for its use was for analysts and investors to make an educated guess as to whether a fast-growing company deserves a high price-earnings ratio. This ratio, and even the dividend-adjusted PEG ratio, may not be appropriate for large, mature companies that pay a large portion of earnings out in the form of dividends.

The PEG calculation also uses earnings per share growth rates. The historical growth rate is easy enough to calculate with accuracy, but the growth estimate depends on analysts and these figures can be highly inaccurate or hard to find.

In addition, there is no consensus on the time frame that should be used. Appropriate time frames will be different for cyclical and non-cyclical companies.

Click here for more articles in the Financial Statements Series.

Joe Lan, CFA is a financial analyst at AAII.


Discussion

Robert Jarvis from GA posted 2 months ago:

Good article; PEG is the second data point, after PE, I examine when deciding to follow or buy a stock. Low PEG ratios also help me find under appreciated securities which has paid off many, but of course not all, times.


Alvin Hawk from AL posted 2 months ago:

I HAVE WATCHED THIS NUMBER. I THINK THAT IT IS A
GREAT METHOD OF EVALUATION.


Thomas Nevers from AZ posted about 1 month ago:

I'm confused about adjusting for dividends. Since dividends are included in net income, seems that you are double counting dividends with your dividend adjustment formula. Let me know if I am missing something.


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