Why should a stock have a PEG (price/earnings to growth) ratio equal to 1 in normal circumstances?

Question

I have read that many financial analysts believe a stock is overvalued if its PEG ratio is greater than 1. Conversely, if a stock's PEG ratio is less than 1, many believe it is undervalued. I don't understand why, in a rational and efficient market, the P/E is supposed to reflect a stock's future earnings growth. For instance, a mature company's stock can have a projected EPS growth rate of 0, but people are still willing to pay something for a future stream of constant earnings.

Answer 1

Ratios are for lazy people who don't want to do the work. They are correlated with things we care about -- so people use them. But they forget that they have to be careful. Comparing ratios of two similar companies may make sense -- but rarely makes sense when the companies are dissimilar.

People finally realized this about PE ratios -- because they realized that growth rates affect PE ratios. Instead of getting it right -- they said "Hey! Let's divide the PE ratio by the Growth Rate!"

Let's take a closer look.

A company's value is equal to the present value of its future cash flows. The reason why PE ratios can be interesting is that for mature companies Earnings is a good approximation to cash flowto equity. This means that the following relationship should be close to the truth:

P = E/(r-g)

Here, P is price, E is Earnings per Share, r is the expected return on the stock anf g is the growth rate.

This means that we should get

P/E = 1/(r-g)

We should be able to get a PE ratio for the market from this. The r for the market is the risk free rate plus the market premium. That should be about 12% right now. For the growth rate, we can use 7%. The real growth rate for the economy is 3% to 4%. Adding in inflation gives us about 7%. Plugging this into the formula, we get a PE ratio of 20.

This is actually close to the PE ratio of the S&P 500 -- which has fluctuated between 18% and 22& over the past few years.

If we divide 20 by 7 (the growth rate) we get a PEG ratio for the market of about 2.85.

If the PEG rato of the market is 2.85, then saying that a normal stock should have a PEG ratio of 1 seems a bit off. I do see how people say that if it is under one then it is probably underpriced. But in reality, it could be fairly priced and a low growth stock -- or it could be overpriced and a highly risky stock with a low growth rate.

Answer 2

The market may be efficient, but there is still considerable difference of opinion about the future earnings potential of a company. The PEG ratio is determined by averaging the earnings forecasts from leading analysts from places like Goldman Sachs.

A PEG ratio higher than 1 means that stock investors, considered as a whole, estimate the earnings potential of the stock (as reflected in the current price) higher than the surveyed analysts.

A PEG ratio lower than one means that the stock market estimates the earnings potential lower than the analysts.

Answer 3

Tom Gardener and his bro, in Motely Fool and their books have pretty much reduced it to easily understood.
The relationship between PE and PEG fluctuates in a band, ranging from REALLY UNDERVALUED, to REALLY OVERVALUED. Simple.
Of course this assumes you trust all the backward looking numbers used to arrive at these ratios.
While it can work, I will echo what others have said:

THINGS CHANGE.

All this relationship of ratios reflects is: What some accountants who hope their opinions will fit GAAP, and what the final judgement of the financial markets beleive, on any given day.

Statistics, IMHO, on the NFL, operate in more or less the same way. After all they are businesses, with huge human elements "attempted" to be figured in....

Good Luck

Answer 4

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