Don't Get Hooked On The PEG

Published in Investing on 25 January 2011

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.

> Try The Motley Fool's Share Dealing Service. You can buy and sell shares in real time for a flat rate of just £10. Click here for more details or to open an account.

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Comments

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F958B 25 Jan 2011 , 3:53pm

Some of the old yardsticks were developed in different times - such as the low-ish inflation era of gold-back currencies (when gilt:equity yield ratio was around 1), or the high-ish inflation era of post-gold-backed currencies (when the gilt:equity ratio was around 2 to account for inflation devaluing bonds).

Company profit growth may well be higher during inflationary times due to year-on-year price increases (especially if you're a commodity producer). On the other hand, low-inflation times can result in lower profit increases.

In my opinion, PEG is a near-useless measure of value and I place no "worth" on its erratic outputs.

Setting defined "absolute" numbers as buying targets will result in you having to stay out of the market for a long period. A far better method is the *relative* value system, where you rank companies against each other and choose those with the best balance of features to suit your investment needs - with a few criteria to prevent overweighting any one sector.
For example, in the simplest sense, you could select the ten shares with the lowest P/E, and as a diversification tool you don't allow more than 15% in one sector.

mcturra2000 25 Jan 2011 , 8:56pm

Some interesting quotes from the great man himself, Anthony Bolton in Investing Against The Tide (page 75): "Two valuation methods I have less time for are PEG ... and ... discounted cashflow models. ... I would go for the 5 times earning growing at 5 per cent every day".

guykguard 26 Jan 2011 , 1:55pm

@F958B
Couldn't agree more. Anyone who's been remotely close to a real business knows what a hazardous game forecasting is, especially the future, for those inside it who know something about it. Forecasting growth rates is the economist's astrological clock. For an outsider who doesn't really know much about the business concerned, PEG is sucking numbers out of thumbs.
In the few cases where PEG can be more or less predicted, it's likely to be a big old favourite of a firm, P&G say, where reasons for investing in it (or not) will have little or nothing to do with PEG.
Those of us who remember JS in the '60s will know he did some good things, but there are some ghosts in his closet, too. PEG is just one. Nice one, Mr Slater!

phil200 26 Jan 2011 , 8:30pm

Great article especially as I like the PEG selection criteria as a starting point.

Can you explain the rationale for using the 13.3% growth rate for Tesco please, which I presume is for the financial year ending Feb 12 ?

Is it because we are so close to the end of the current financial year (Feb 11) and have had the interims on 05/10/2010 plus a trading statement on 13/01/2011 which effectively says "growth is on track/as forecasted", so the current forecasts are in the bag and are already included in the price, so you have to look to the next set of forecasts ?

Phil.

MrContrarian 27 Jan 2011 , 8:57am

Can you explain the rationale for using the 13.3% growth rate for Tesco please, which I presume is for the financial year ending Feb 12 ?

The number is from Hemscott using REFS data ie straight from the horse's mouth (Slater founded REFS).

REFS says this about growth "Growth refers to the rate of increase in normalised EPS and is measured, when possible, on a rolling 12 months-ahead basis, using forecasts...EPS must be apportioned, giving estimated EPS values for the 12 month periods either side of the point of measurement."

phil200 27 Jan 2011 , 7:01pm

Thank you for the info. The the key word in the REFS description is "rolling"

When I looked at the forecasts for TSCO yesterday, it was 2% growth for the year ending Feb 11 and about 13% for Feb 12. I thought the article was exclusively using the forecast for Feb 12 however it must be using 1/12th of the 2% and 11/12th's of the 13%.

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