PEG Ratios work better with individual stocks than they do for the market as a whole, which might make you scratch your head wondering why, the market is after all made up of stocks, but it is the truth. The evaluation actually needs to be skewed slightly when considering the market as a whole, so within this article I explain how to attribute the necessary skew to your PEG valuation of the market itself.
Let's begin by looking at some of the best PEG rations in the S&P 500. These PEG ratios make these companies appear to have excellent valuations when compared to the general market, but careful additional insight is required before investment can be made of course. For example, we all know that Apple (AAPL) has recently come under considerable EPS pressure and growth rates going forward may not be what they have been in the past.
Using a pure-PEG comparison the S&P 500 is currently trading at a 3.53 PEG Ratio. This is derived using a simple formula, the one every uses for PEG: ((P/E)/G) when G = Growth. In this exact instance the past four quarters of growth for the S&P 500 have averaged 5.76%, and most analysts believe this growth rate will subside given the pressures to GDP that exist in the current economy.
However, using the most likely higher growth number of 5.76%, and the current P/E of the S&P 500, which is 19.25, we get a PEG ratio of 3.34. By anyone's measure that is a very expensive measure, and if the stocks you were considering had PEG Ratios like that you would think twice. The market is not valued like that though; in fact the norms for market valuation typically are based on a multiple.
Specifically, investors are usually willing to pay about 2.5x EPS Growth to assume the risk right now, and in the current environment are not near that norm. Using the multiple - valuation method fair value for the S&P 500 is 14.4x earnings, assuming of course EPS Growth continues at the rate it has in the past four quarters (unlikely). With a current P/E of 19.25, that makes the S&P about 25% overvalued based on a fair market valuation analysis, taking no added risks into the equation.
Some of the best PEG ratios on the S&P:
Toyota Motor Corporation Common (TM)
Bank of America Corporation Com (BAC)
Citigroup, Inc. Common Stock (C)
Intel Corporation (INTC)
Unique conditions must always be considered as well, but one of the most obvious comparisons is always to compare the stocks being considered to the market itself. When doing this many people make the initial assumption that the Market carries a fair valuation, they might even do that without knowing it because this is how traditional investment philosophy has guided investors, and it is the situation that exists when the Market is overvalued that is important here because it actually exists today.