PEG is one of the most popular multiples used in the analysis. Indeed, it is very logical to adjust the standard P/E multiple for the earnings growth rate and get another multiple which takes into account the speed of growth of the company's earnings, so that you can compare companies located on the different stages of their business cycles. At first glance, this should be very effective.
For a greater visibility let's take this approach to compare Apple (AAPL) with companies on the FAAMG list:
Despite the fact that in the last quarter Alphabet (NASDAQ:GOOG) (GOOGL) and Microsoft (MSFT) both showed negative EPS growth, and, therefore, the PEG cannot be calculated for these companies in the usual way, the comparison of Apple with Facebook (FB), Amazon (AMZN), and Alibaba Group (BABA) gave a very rosy picture of 30% growth potential of Apple’s shares.
But to what extent can this conclusion be trusted? I mean, how accurately did this multiple predict the stock potential in the past?
This issue kindled my interest, and I performed quick research. Please find its results below.
Here's what I did.
I calculated the daily PEG values (using the standard formula) starting from 2015 onwards for each company on the FAAAMG list. You can find the calculation sheets at the end of this post.
Next, I calculated the daily implied Apple stock price based on the comparison of its PEG with those of other companies on the FAAMG list, i.e., using the same algorithm, which gave me 30% growth potential of Apple’s shares at the beginning of this post.
So, here's the first chart that displays the results without any adjustments:
Well, what can I say... the growth potential of more than $2,000 recorded in the second half of 2015, when Apple’s shares were clearly bearish, sows the seeds of doubt in this multiple.
Now let’s take a look at the period from 2017 onwards:
We see the same thing: There's no explicit dependency or the time lag between Apple’s stock dynamics and the implied price based on the PEG comparison. There’s even a sense that these two charts are not related.
Next, I decided to smooth out the chart of the implied price, counting the PEG multiple by dividing the P/E by the two-year CAGR of the EPS growth. Here's the chart:
The result is more adequate, but still not very useful: In long periods during the decline of Apple’s stock price, the PEG-based forecast demonstrated substantial underestimation and vice versa. Perhaps the only interesting thing which can be identified is that over the last two months, the implied price of Apple’s stock has been almost perfectly matching with the actual one.
It's difficult to draw any general conclusions based only on the analysis of Apple, so I've performed this entire set of calculations for Microsoft as well.
Here's the chart on which the implied price of Microsoft’s shares was determined based on the comparison of its PEG multiple with those of Facebook, Apple, Alibaba, Amazon and Alphabet:
From 2014 to Q1 2016, Microsoft demonstrated reduced EPS and, therefore, you cannot calculate its PEG for that period. But starting from the Q2 2016 and up to the Q4 2017, Microsoft’s EPS demonstrated growth, and the PEG-based implied price was almost always higher than the actual price. It remains to add that during this period, Microsoft's share price rose by more than 70%.
In the Q1 and Q2 2017, Microsoft showed the negative EPS growth, thus, there's no possibility to evaluate the company through PEG.
It's probable my quick research generated more questions than answers, but still, some conclusions can be drawn.
Firstly, if someone says that Apple is undervalued on the PEG multiple in comparison with the FAAMG companies, you should not believe it. The history teaches that it normally doesn’t mean anything.
Secondly, Microsoft's history of the past three years allows us to trust the PEG multiple. At least the growth of stock in 2017 fully corresponded to the potential calculated based on PEG.
Thirdly, you should take any multiple-based analysis with a grain of salt and study the history of the quality of such predictions.
In the future, I intend to take the same approach to assess the predictive value of other common multipliers.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.