The Fallacy of Price/Earnings to Growth Ratios

Abstract

Price/earnings to growth (PEG) ratios are based on mathematics, but shockingly, the PEG ratio is only accurate under a very specific set of circumstances that are rarely ever met in the investment market place. Does the PEG ratio have any basis in reality and can you trust it? In our discussion, we offer case studies of Facebook and Extended Stay America and conclude that the PEG ratio is dangerous to use for businesses trading at high P/Es. Earnings growth rates simply cannot keep up with the high initial purchasing cost. In the Facebook example, if all other variables are held fixed, including the 10-year earnings growth rate, but you pay only 35 earnings, then the growth rate needed to break even is “only” 150.8%.

For businesses with PEG ratios less than 1.0, caution rises in proportion to the magnitude of the P/E. The higher the P/E the more dangerous is the PEG ratio; and the danger rises exponentially, not geometrically. The PEG ratio breaks down in that it doesn’t account for the time value of money, makes no assumption for how to reinvest earnings, and doesn’t factor in the investment time horizon. What is the special case where the PEG ratio holds? The ratio holds when your desired rate of return and your earnings reinvestment rate are equivalent to the earnings yield of the business.

TOPICS: Private equity, accounting and ratio analysis, statistical methods, technical analysis