speedybure (< 20)

Will The Real PEG Ratio Please Stand Up

June 11, 2009 – Comments (2)

Something got lost in translation when investors adopted his PEG ratio. You average investor defines this ratio as the next 3-5 years growth in earninigs divided by the TTM P/E ratio.It is considered ideal if this is <1, the lower the better. It's not that I don't think this could be useful assuming you possess superior forecasting abilities, but more often than not, I see everyday investors (that which knows little to nothing regarding equity valuation) take this ratio to heart and put a incorporate this into their decision making. 

 The Real PEG ratio invented by Peter Lynch was nothing more than one of the many qualataive tests he put potential investments through. It was a requirement that the TTM P/E divided by the average growth in earninigs over the past 3-5 years be under 1.

Personally I am not to fond of either the P/E or PE/G but have created my own versions which incorporates some adjustments.

 1) Instead of P/E, I use Enterprise Value, which in my opinion is far more revealing and incorporates debt. I also go through the annual report and add off balance sheet debt (far more common than anyone thinks).

 2) Instead of using earninigs Growth, I Take EBIT growth less any one time items. This paints a clear picture of the actual growth from operations. As a non-practicing CPA, deferred taxes in any given year is more than likely. 

This was not meant to say the former ratio was wrong or faulty as finance is an art, but merely to point out to those who think that was the original formulation of the ration.