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Price-to-Earnings Ratio ExpandedWhat Is Captured in a Company's P/E Ratio Relative to Its EPS Growth
There is much more to evaluating a company than what is captured by its P/E ratio. Let's see how the PEG ratio factors into the company's valuation process.
In the article Master Price-to-Earnings Ratio, the underlying assumption is that the higher the P/E ratio, the higher the expected future earnings. Unfortunately, this is also the P/E ratio’s worst limitation. You surely remember the “dot.com” era, when things were heating up at an alarming rate, and when technology companies traded at exorbitantly high earnings multiples. In hindsight, those high P/E ratios were obviously inadequate tools when evaluating companies' long-term earnings potential. Startups, which littered the stock markets during the tech bubble of the late 1990s, typically had extremely high P/E ratios. Why? Basically, startups are companies still in early development stages, generating little or no revenues. But as many analysts and investors perceived it, many startups at the time also potentially held the promise of advanced technological breakthroughs, or miraculous new drug candidates in late stage clinical trials, or gold mineral deposits that could catapult junior miners into the big leagues as soon as the first ounces were extracted, etc. And while all of this sounded very promising and exciting, it also proved to have completely missed the "target" when evaluating such companies. This Is Where Price-to-Earnings-Growth Ratio Comes in Handy...In spite of its limitations, it is not to say that analyzing P/E ratios will take your evaluation entirely in the wrong direction. This is because the P/E formula still contains loads of important information. What we are implying is that there is so much more to this story. Whenever analysts’ scrutinize a company, one of the first things they look at are the company’s earnings. After all, earnings are the reflection of a company’s profits. True, due to inherent problems with how financial statements are constructed, a company’s management could, and far too many already did, manipulate earnings. For example, management could treat inappropriately one time and nonrecurring items by placing them above or below “the line” on income statements when it suited them, rather than as warranted by the U.S. Generally Accepted Accounting Principles (GAAP). Or, unexpected foreign exchange gains could be treated as cash flows from operations. Or, the management could use other aggressive accounting measures that overstate revenues and understate costs. However, what management cannot manipulate, at least not for very long, is the earnings’ growth rate. There is so much more to the earnings' growth rate than what goes into simply calculating a company’s earnings or P/E ratio. We are talking about factors such as the quality, demand and competitive advantage of a company’s product; strength of its management; market share, production capacity, inventory levels, etc. All of these play important roles in the company’s rate of earnings growth. What Is PEG Ratio?In layman’s terms, the PEG ratio captures the relationship between a company’s P/E ratio and the rate of its earnings growth. The Price-to-Earnings-Growth (PEG) ratio is calculated by dividing P/E ratio with the company’s EPS annualized growth rate. As far as the underlying assumption for the PEG ratio goes, it is the same as for the P/E ratio; which is, the higher the PEG ratio, the more valued are a company’s earnings. However, a word (or more) of caution seems also prudent at this point. The beauty of the PEG ratio is not in the eyes of a beholder, but in the details. For example, let us assume that the annual EPS growth rate of a mid-cap wireless company is 50, and that its P/E ratio is very high at 100. That being the case, the wireless company’s PEG ratio would be 2.0 (100/50 = 2.0). And, let us also assume that a mid-cap specialty retailer has the annual EPS growth rate of 24, while its P/E ratio is 12. As a result, the retailer’s PEG ratio would also be 2.0 (24/12 = 2.0). But which company is a better choice, given that both have identical PEG ratios? In financial analysis, nothing is taken at face value. The difference between the two companies is obviously in the quality of their earnings. While the wireless company at face value appears more attractive, it is more likely that it is reporting what seems to be an unsustainable earnings growth rate. But how could a company even have an EPS growth rate so high? Well, here we go back to the issue of management’s manipulation of earnings. One plausible scenario could be that the wireless company has taken a “big bath” in previous quarters, perhaps absorbing a huge impairment charge on a long-term asset, while the retail company’s management employed more conservative accounting measures that kept its earnings growth rate at a more sustainable pace. In any event, hopefully today’s investors understand that the P/E ratio taken at face value is no longer sufficient when evaluating a company. It still plays a role, but more along the lines of comparing an individual company against its competitors and the industry within which it operates. The PEG ratio, on the other hand, offers much more insight into a company, and as such, represents a much more accurate indicator of a company’s value, provided, of course, it is analyzed along other key financial ratios. (Source: Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly and Keith C. Brown, 2005; Analysis of Equity Investments: Valuation, by John D. Stowe, Thomas R. Robinson, Jerald E. Pinto, and Dennis W. McLeavey, 2002)
The copyright of the article Price-to-Earnings Ratio Expanded in Investment is owned by Inya Ivkovic. Permission to republish Price-to-Earnings Ratio Expanded in print or online must be granted by the author in writing.
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