Investors use ratios to identify potential investment opportunities.
The most common is the P/E ratio, ‘price to earnings’.
This is printed in the financial press daily as part of each individual shares information along with dividend yield and high/low prices in the last 12 months.
The P/E ratio tells an investor the multiple of earnings at which the share is being priced. The major indices trade over cycles at an average P/E of around 15 times earnings however some sectors are generally lower (utilities, telecoms) and some higher (technology, biotech).
The P/E ratio however only tells part of a story, it tells the price to current earnings but does not factor in the future rate of the growth of those earnings.
This is an important omission and the ‘PEG’ ratio adds an additional layer of information to address this.
The PEG of a company is the P/E divided by the projected earnings growth, when the number produced is below 1 this can indicate an attractive opportunity.
Why do future earnings matter?
If the investor simply uses the P/E ratio to rationalise buying when the prices are low for instance, the price is known and current but the earnings element of the ratio is historic. If the future earnings trajectory of a company is falling then the P/E will either go higher or stay the same as the share price falls; either way is not good.
The future earnings growth of a company is therefore a vitally important element of assessing a stock’s potential.
Value investors looking to identify long term investments in undervalued companies will use the PEG to highlight stocks with a margin of safety and the potential to consistently grow earnings to compound into significant stock price appreciation over time (this is Warren Buffett’s methodology with companies such as Coca Cola, Johnson and Johnson, Walmart).
Growth investors will use the PEG to identify opportunities where a future rapid acceleration in growth rates is underestimated by the market, making a Company cheap to buy, not by historic earnings but on future growth.
Our own view is that the value investment method has a far greater chance of being an accurate predictor of future occurrence. Companies which have a strong brand, long term competitive advantage, suffer low creative destruction and which have some pricing power are far more predictable than new disruptive companies with revolutionary products.
The PEG helps identify the occasions that the market temporarily loses confidence in these steadier compounders of value and offers low prices.
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.