A New Spin On The Price/Sales Ratio: The PSG Ratio

Jun. 12, 2015 3:04 AM ETAAPL, ACHC, AE, OPCH, BRG, NEX, CTIC, CTRX, CZNC, ECYT, FSIC-OLD, GPT, BATL, INT, LC, MDXG, LUMO, NOG, DBRG, OREX, P, PACB, PARR, PBF, ALTO, PSG, QUAD, RCAP, CVX, REI, RUSHA, SHLO, SPTN, SSE, SRCI, TA, TWO, UDF, VVX, VMEMQ, ZEUS, ZLTQ20 Comments
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Dr. J's Good Ideas
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Summary

  • Peter Lynch introduced the concept of PEG over two decades ago. While it is a great concept, it has its limitations.
  • Price-to-sales ratio was popularized by Ken Fisher. It, too, is a great idea, but also has its shortcomings.
  • What if we compared the price/sales ratio to a company's sales growth rate? Here we find out.

Many of us who utilize stock screen programs have seen the PEG option; the Price-to-Earnings Ratio to Earnings Growth. According to Peter Lynch, "The p/e ratio of any company that's fairly priced will equal its growth rate. I'm talking about growth rate of earnings here." Later, he says, "We use this measure all the time in analyzing stocks for the mutual funds."

Timothy Connolly goes one step further, and says, "If we think about what Lynch was saying in terms of a formula, we could say 'Fair P/E = Growth rate.' Dividing both sides by the growth rate yields 'Fair P/E/Growth rate = 1.'" According to Lynch, "a p/e ratio that's half the growth rate is very positive, and one that's twice the growth rate is very negative." Essentially this means he looked for companies with a PEG less than 0.5.

There are limitations to this function, and I won't get into all of them, but it is worth pointing out that it has two mathematical drawbacks, from it being a piecewise operation. First, it assumes that a company has been profitable for the trailing 12 months. For any company to have a P/E ratio, it has to be profitable. While that is usually a good thing, it does eliminate young companies that are not yet in the black from any consideration. For one who is looking for the next big stock, the analyst might miss opportunities if s/he were solely reliant on PEG. Second, it only works if the growth rate for earnings is positive. Again, this is not a negative, but if one is not careful in their workflow, then it is conceivable that one could divide a negative P/E with a negative growth rate and yield a positive result; that cannot happen.

In researching a way around

This article was written by

Dr. J's Good Ideas profile picture
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I am a an investor who likes sharing great ideas.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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