Wednesday, June 25, 2008

Take That PEG Ratio and Shove It

A quick economics lesson of the day here and that is the PEG ratio.

A lot of people look at a P/E ratio as a means to determine whether a stock is under or overvalued. The price divided by the earnings of a share of stock (thus, P/E) shows how much you're paying in stock price to be entitled to one dollar in earnings. Thus a P/E of 100 means you're shelling out $100 in price for $1 in earnings and a P/E of 4 means you're only paying $4 in price for that same $1 in earnings.

The problem though, is with P/E ratios they don't account for growth. So a company could be making very little now, but if its earnings grow by, say, 500%, then it will be making sizable profits in the future.

This phenomenon was played out in Dotcom P/E ratios in the late 90s. Yahoo for example had a P/E of 571 at its peak in 1999. Obviously nobody was willing to pay $571 for a $1 in earnings, but it was the promise of future earnings growth that warranted such a high P/E ratio.

Thus to account for the prospect of growth they developed the PEG ratio - Price Earnings Growth. The original version discounted the P/E ratio by one year's worth of expected earnings growth. Thus the higher the growth, the lower the PEG ratio and thus the better "deal" you'd get.

However, there's just one minor problem. Stock markets are notoriously optimistic and overestimate growth. An interesting chart on Wikipedia from Robert Shiller shows the correlation between P/E ratios and their 20 year annualized return and it shows (commonsensically enough) that the lower P/E stocks had higher returns.

This counters, or at least gives reason to question any broker or smooth talking investment banker trying to push or sell the latest stock or technology saying "well, even if it has a P/E ratio of 300, it's still a great deal because of all the future growth that will occur." History has suggested, over various periods of time, we overestimate growth and do not value low P/E ratios as much as we should.

Of course this suggests something very obvious; the less you pay for a stock, the better deal you'll tend to get. I think people would become infinitely better investors if they treated buying stocks like buying gas; you want the price of it as cheap as possible when you buy. It's only when you sell do you want the price to go up.


Anonymous said...

OK, so the current trailing DJIA P/E is about 80--hardly a deal by any means. Forecasts put the DJIA forward P/E in the upper teens a year from now.

Either prices will drop by some 3/4s or earnings are going to shoot up in ways that no one expects.

I'm betting on prices going down.

Anonymous said...

If the Shiller graph captures a common market phenomenon, some wise person should already have started a "LOW P/E Mutual Fund" and been able to make lots of money. Why hasn't this happened?

Anonymous said...

Basically speaking they have. They're low priced or "value" investing funds.