banter
27-10-2015, 03:41 PM
PEG ratios
The PEG ratio can be used to try and find underpriced shares. It’s the PE ratio divided by the ‘growth rate’ – which is the investor’s estimate of likely annual percent growth in coming years.
Peter Lynch (https://en.wikipedia.org/wiki/Peter_Lynch), wrote in his 1989 book One Up on Wall Street that "The P/E ratio of any company that's fairly priced will equal its growth rate", i.e., a fairly valued company will have a PEG of 1.
I got to wondering what was more important – growth or dividend yield? And by how much? What’s better – a company with a net yield of 13% and a growth rate of 4% - or a dividend yield of 4% and growth of 13%?
In the above example, Peter Lynch would say the 4% growth company should be on a PE of 4, and the 13% one on a PE of 13. I made a model to investigate this.
The model took some hypothetical companies with growth rates ranging from 4% to 14%. It assumed the companies pay out 70% of their earnings in dividends, all over a seven year period. It asked the question:
What should the PE be for each of these companies in order that an investor get the same compound annual growth rate (CAGR)?
The answers depend a bit on what CAGR is used, so the model looked at CAGRs of 14%, 15% and 16%.
Equal-return PE values,
for given CAGRs and %growth factors
CAGR %
GF%
16%
15%
14%
5%
4.7
5.2
5.8
6%
5.3
5.95
6.8
7%
6.1
6.9
7.9
8%
7.05
8.1
9.5
9%
8.3
9.7
11.7
10%
10
12
15
11%
12.4
15.5
20
12%
16
21
30
13%
22
32
56
14%
34
62
300
The chart of this data (below) is asymptotic – almost linear for lower growth factor percentages, and then rising rapidly. Note the theoretical PE of 300 for 14% growth and 14% CAGR (omitted in the chart because it is literally off the chart)
7689
Note also that for lower CAGRs and higher GF% factors, the theoretical PE rapidly goes off the scale, to hundreds, thousands, or unattainable. For example, the theoretical PE for a CAGR of 10% and growth rate of 10% is 1,500.
So back to Lynch's statement that PEGs should be 1 - the table below shows theoretical PEG values, derived from the table above.
With CAGR% of 14-16%, and growth rates under 10%, Peter Lynch’s ‘PEG should be 1’ statement more-or-less holds. But for growth rates above 10%, the ‘equal return PE’ rapidly goes off the scale and generates very high (or infinite) PEs, and the theoretical PEG is much higher than 1.
Equal-return PEG values,
for given CAGRs and %growth factors
CAGR
GF%
16%
15%
14%
5%
0.9
1.0
1.2
6%
0.9
1.0
1.1
7%
0.9
1.0
1.1
8%
0.9
1.0
1.2
9%
0.9
1.1
1.3
10%
1.0
1.2
1.5
11%
1.1
1.4
1.8
12%
1.3
1.8
2.5
13%
1.7
2.5
4.3
14%
2.4
4.4
21.4
Conclusions
1) This model suggests that the market might tend to undervalue high growth companies. And that’s its worth looking for companies that have high growth. I think this effect explains the very high PEs seen in, for example, the retirement sector.
2) It also suggests that the market tends to overvalue low growth companies.
3) It suggests that a higher PEG than 1 should apply for companies with growth factors above 10% - much higher above 13%.
By this model I think there are quite a few undervalued companies on the NZSE.
The PEG ratio can be used to try and find underpriced shares. It’s the PE ratio divided by the ‘growth rate’ – which is the investor’s estimate of likely annual percent growth in coming years.
Peter Lynch (https://en.wikipedia.org/wiki/Peter_Lynch), wrote in his 1989 book One Up on Wall Street that "The P/E ratio of any company that's fairly priced will equal its growth rate", i.e., a fairly valued company will have a PEG of 1.
I got to wondering what was more important – growth or dividend yield? And by how much? What’s better – a company with a net yield of 13% and a growth rate of 4% - or a dividend yield of 4% and growth of 13%?
In the above example, Peter Lynch would say the 4% growth company should be on a PE of 4, and the 13% one on a PE of 13. I made a model to investigate this.
The model took some hypothetical companies with growth rates ranging from 4% to 14%. It assumed the companies pay out 70% of their earnings in dividends, all over a seven year period. It asked the question:
What should the PE be for each of these companies in order that an investor get the same compound annual growth rate (CAGR)?
The answers depend a bit on what CAGR is used, so the model looked at CAGRs of 14%, 15% and 16%.
Equal-return PE values,
for given CAGRs and %growth factors
CAGR %
GF%
16%
15%
14%
5%
4.7
5.2
5.8
6%
5.3
5.95
6.8
7%
6.1
6.9
7.9
8%
7.05
8.1
9.5
9%
8.3
9.7
11.7
10%
10
12
15
11%
12.4
15.5
20
12%
16
21
30
13%
22
32
56
14%
34
62
300
The chart of this data (below) is asymptotic – almost linear for lower growth factor percentages, and then rising rapidly. Note the theoretical PE of 300 for 14% growth and 14% CAGR (omitted in the chart because it is literally off the chart)
7689
Note also that for lower CAGRs and higher GF% factors, the theoretical PE rapidly goes off the scale, to hundreds, thousands, or unattainable. For example, the theoretical PE for a CAGR of 10% and growth rate of 10% is 1,500.
So back to Lynch's statement that PEGs should be 1 - the table below shows theoretical PEG values, derived from the table above.
With CAGR% of 14-16%, and growth rates under 10%, Peter Lynch’s ‘PEG should be 1’ statement more-or-less holds. But for growth rates above 10%, the ‘equal return PE’ rapidly goes off the scale and generates very high (or infinite) PEs, and the theoretical PEG is much higher than 1.
Equal-return PEG values,
for given CAGRs and %growth factors
CAGR
GF%
16%
15%
14%
5%
0.9
1.0
1.2
6%
0.9
1.0
1.1
7%
0.9
1.0
1.1
8%
0.9
1.0
1.2
9%
0.9
1.1
1.3
10%
1.0
1.2
1.5
11%
1.1
1.4
1.8
12%
1.3
1.8
2.5
13%
1.7
2.5
4.3
14%
2.4
4.4
21.4
Conclusions
1) This model suggests that the market might tend to undervalue high growth companies. And that’s its worth looking for companies that have high growth. I think this effect explains the very high PEs seen in, for example, the retirement sector.
2) It also suggests that the market tends to overvalue low growth companies.
3) It suggests that a higher PEG than 1 should apply for companies with growth factors above 10% - much higher above 13%.
By this model I think there are quite a few undervalued companies on the NZSE.