I’m no wine connoisseur, but I do know I would pay more for a bottle of Dom Pérignon champagne than I would pay for a container of Franzia box wine. In the world of stocks, the quality disparity is massive too. In order to navigate the virtually infinite number of stocks, we need to have an instrument in our toolbox that can assist us in accurately comparing stocks across the quality spectrum. Thank goodness we have the handy PEG ratio (Price/Earnings to Growth) that elegantly marries the price paid for a stock (as measured by the P/E ratio) with the relative quality of the stock (as measured by its future earnings growth rate).
Famed investor Peter Lynch (see Inside the Brain of an Investing Genius) understood the PEG concept all too well as he used this tool religiously in valuing and analyzing different companies. Given that Lynch earned a +29% annual return from 1977-1990, I’ll take his word for it that the PEG ratio is a useful tool. As highlighted by Lynch (and others), the key factor in using the PEG ratio is to identify companies that trade with a PEG ratio of less than 1. All else equal, the lower the ratio, the better potential for future price appreciation.
Facebook (NASDAQ:FB) Vs. Eastman Kodak (EKDKQ.PK)
To illustrate the concept of how a PEG ratio can be used to compare stocks with two completely different profiles, let’s start by answering a few questions. Would a rational investor pay the same price (i.e., Price-Earnings [P/E] ratio) for a company with skyrocketing profits as they would for a company going into bankruptcy? Look no further than the lofty expected P/E multiple to be afforded to the shares of the widely anticipated Facebook initial public offering (IPO). That same rational investor is unlikely to pay the same P/E multiple for a money losing company like Eastman Kodak Co. (EKDKQ.PK) that faces product obsolescence. The contrasting values for these two companies are stark. Some pundits are projecting that Facebook shares could fetch upwards of a 100x P/E ratio, while not too long ago, Kodak was trading at a P/E ratio of 4x. Plenty of low priced stocks have outperformed expensive ones, but remember, just because a “value” stock may have a lower absolute P/E ratio in the recent past, does not mean it will be a better investment than a “growth” stock sporting a higher P/E ratio (see Fallacy of High P/Es).
Price, Earnings, and Dividends
As I’ve written in the past, a key determinant of future stock prices is future earnings growth (see It’s the Earnings Stupid). The higher the P/E multiple, the more important future earnings growth becomes. The lower the future growth, the more important valuation and dividends become.
We can look at various money-making scenarios that incorporate these factors. If my goal were to double my money in 5 years (i.e., earn a 100% return), there are numerous ways to skin the profit-making cat. Here are four examples:
- Buy a non-dividend paying stock of a company that achieves earnings growth of 15%/year and maintains its current P/E ratio over time.
- Buy a stock of a company that has a 5% dividend and achieves earnings growth of 11%/year and maintains its current P/E ratio over time.
- Buy a value stock with a 5% dividend that achieves earnings growth of 5%/year and increase its P/E ratio by 10% each year.
- Buy a non-dividend paying growth stock that achieves earnings growth of 20%/year and decreases its P/E ratio by about 5% each year.
I think you get the idea, but as you can see, in addition to earnings growth, dividends and valuation do play a significant role in how an investor can earn excess returns.
Lynch’s Adjusted PEG
Peter Lynch added a slight twist to the traditional PEG analysis by accounting for the role of dividends in the denominator of the PEG equation:
PEG (adjusted by Lynch) = PE Ratio/(Earnings Growth Rate + Dividend Yield)
This “adjusted PEG” ratio makes intuitive sense under various perspectives. For starters, if two different companies both had a PEG ratio of 0.8, but one of the two stocks paid a 3% dividend, Lynch’s adjusted PEG would register in at a more attractive level of 0.6 for the dividend paying stock.
Looked at under a different lens, let’s suppose there are two lemonade stands that IPO their stocks at the same time, and both companies use the exact same business model. Moreover, let us assume the following:
• Lemonade stand #1 has a P/E of 14x and growth rate of 15%.
• Lemonade stand #2 has a P/E of 12x and growth rate of 8%, but it also pays a dividend of 3%.
Given this information, which one of the two lemonade stands would you invest in? Many investors see the lower P/E of Lemonade stand #2, coupled with a nice dividend, as the more attractive opportunity of the two. But as we can see from Lynch’s “adjusted PEG” ratio, Lemonade stand #1 actually has the lower, more attractive value (.9 or 14/15 vs 1.1 or 12/(8+3)).
This analysis may be delving into the weeds a bit, but this framework is critical nonetheless. Valuation and earnings projections should be essential components of any investment decision, and with record low interest rates, dividend yields are playing a much more important role in the investment selection process. Regardless of your purchase decision thought process, whether deciding between Dom Perignon and box wine, or Facebook and Kodak shares, having the PEG ratio at your disposal should help you make wise and lucrative decisions.