Slater's PEG ratio is a great tool, but it can give false readings.
It wasn't just Internet shares that required oxygen masks to survive at the heights reached in 2000.
Clothes warehouse Matalan hit 800p with a P/E of over 50. Not a price I'd pay. By the turn of 2002, however, growth had slowed and the forward P/E had reduced to 17.5 but with the EPS growth still expected to be a trolley-dashing 33%.
I was pretty keen on the PEG (price earnings growth) ratio, and 0.53 was low for a national chain, so I bought at a 'bargain' 326p.
Paying up for growth
The PEG ratio was Jim Slater's answer to the old question of how much to pay for growth. If a company is growing its earnings consistently at say 15% Slater says that paying a P/E of about 15 is fair value. If PEG is less than 0.75 that's a buy signal (providing his other criteria are met) and above 1.2 a sell signal.
The simplicity of it, and Slater's fame, made the PEG ratio a huge success and as any Hollywood actor will tell you, that will eventually bring unrealistic expectations and abuse.
I fell into the trap and bought Matalan, without checking Slater's other five mandatory buy criteria other than gearing.
The market's punishment was swift. A year later saw the price slumped to 200p as growth stalled. 2004 saw 160p. Matalan confessed that in its blitzkrieg expansion it had been taking any large retail units available, even if they cannibalised sales from an existing store.
I sold out at a thumping loss having bought far too many.
Too good to be true
I read the following on a discussion board recently:
"…this share's PEG is currently 0.07. That means if its price was ten times higher its PEG would still only be 0.7."
A PEG of 0.07 is obviously a short term anomaly and does not mean the share is worth 10 times its current price. Slater calculates PEG using both the EPS forecast for the current financial year and the next.
This is all very well for predictable growers like Tesco (LSE: TSCO) and Compass Group (LSE: CPG), but many companies may not have reliable earnings for the years ahead. Here are a few examples:
- Blue sky outfits and young companies, e.g. Axis-Shield (LSE: ASD);
- Cyclicals coming out of a downturn, e.g. Taylor Wimpey (LSE: TW);
- Firms recently moving into profit from loss or near breakeven, e.g. French Connection (LSE: FCCN), Alkane Energy (LSE: ALK); and
- Resource companies when prices are volatile, e.g. Vedanta (LSE: VED), BP (LSE: BP).
Therefore, I use the historic P/E and the current financial year P/E forecast to calculate growth.
What about dividend payers?
The PEG ratio will unfairly penalise companies that are already paying a dividend. The reason is that the dividend is not available for investment in the business but you still receive the value of it.
John Neff invented the total return ratio (TRR) to give a better number for dividend payers.
TRR = (yield + growth) / P/E
This is very similar to the PEG ratio, but unfortunately it is the other way round. So Tesco at 405p has a PEG of 0.84, but the TRR is 1.55, being (13.3 + 3.9)/11.1.
I use PEG-D instead, which is simply 1/TRR. The PEG-D for Tesco is 0.65. So while Tesco does not pass Slater's PEG hurdle, it does if you adjust for the high dividend paid.
PEG has certainly proven a useful tool but Jim Slater didn't think that all you need to know about growth and value could be condensed into one number.
The cynical, careful and methodical get rich slowly. The rash get rich only through luck.
More from Alun Morris:
> Alun owns shares in French Connection and BP.
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