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PEG ratio - why is 1 the magic number?
Posted on 1/15/17 at 1:19 am
Posted on 1/15/17 at 1:19 am
quote:
Theoretical perfect correlation between market value and projected earnings growth assigns a PEG ratio value of 1 to a stock. PEG ratios higher than 1 are generally considered unfavorable, suggesting a stock is overvalued. Conversely, ratios lower than 1 are considered better, indicating a stock is undervalued.
https://www.investopedia.com/ask/answers/012715/what-considered-good-peg-price-earnings-growth-ratio.asp
I understand how to calculate PEG ratios, and I understand why a lower PEG ratio indicates better value. However, I can't figure out why "1" is the magic PEG ratio that indicates "perfect correlation between market value and projected earnings growth."
Can anyone explain?
Posted on 1/15/17 at 2:06 am to Jon Ham
I don't think it has any theoretical basis. I think it's more of a rule of thumb derived from Peter Lynch's quote in his 1989 book, "The P/E ratio of any company that's fairly priced will equal its growth rate."
More fully ( LINK):
"The p/e ratio of any company that's fairly priced will equal its growth rate ... If the p/e of Coca-Cola is 15, you'd expect the company to be growing at about 15 percent a year, etc. But if the p/e ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year ... and a p/e ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a p/e ratio of 12 is an unattractive prospect and headed for a comedown."
I suppose this rule of thumb made sense for the particular interest rate and inflation conditions of 1989, but I'm not sure how well it holds today. From 1989 to 2016, S&P 500 earnings ( LINK) increased from 43.84 to 87.17, for a real growth rate of less than 2.6%. You can throw in inflation, but that was less than 2.5% per year for that time period, so you still only get a little over 5% nominal growth rate. Does that mean the S&P 500 stocks should have P/E ratios of 5?
What about cash cow stocks that might have slightly negative growth rates? Why include an arbitrary multiplication by 100 to get a percent figure? I suppose there might be something I'm missing, but it looks to me like a merely coincidental rule of thumb that worked well in the 1980s.
More fully ( LINK):
"The p/e ratio of any company that's fairly priced will equal its growth rate ... If the p/e of Coca-Cola is 15, you'd expect the company to be growing at about 15 percent a year, etc. But if the p/e ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year ... and a p/e ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a p/e ratio of 12 is an unattractive prospect and headed for a comedown."
I suppose this rule of thumb made sense for the particular interest rate and inflation conditions of 1989, but I'm not sure how well it holds today. From 1989 to 2016, S&P 500 earnings ( LINK) increased from 43.84 to 87.17, for a real growth rate of less than 2.6%. You can throw in inflation, but that was less than 2.5% per year for that time period, so you still only get a little over 5% nominal growth rate. Does that mean the S&P 500 stocks should have P/E ratios of 5?
What about cash cow stocks that might have slightly negative growth rates? Why include an arbitrary multiplication by 100 to get a percent figure? I suppose there might be something I'm missing, but it looks to me like a merely coincidental rule of thumb that worked well in the 1980s.
Posted on 1/15/17 at 10:15 am to Jon Ham
1 means the market is efficient. Your growth and current value are projected at the same price.
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