Are You Foolishly Playing the PEG Game?

Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Valuation is the single biggest factor to successful equity investing.  Whether it is individual names or a diversified index fund, valuation is the key factor to long-term return expectations.  The Achilles heel of using valuation when doing security analysis is its horrible track record during shorter intervals.  Although short by historical standards, a stagnant or declining stock price that persists for one, two, or even up to five years can hinder portfolio performance and create plenty of second guessing.  The price-to-earnings ratio is the Cadillac of valuation ratios.  Whether it deserves this acclaim is irrelevant given its overwhelming popularity in both professional as well as amateur circles.  Derivatives of this ratio have been gaining in popularity in recent years.  One such ratio, the price-to-earnings-to-growth (PEG), has become more commonplace in recent years.  Does this ratio deserve its popularity?  Should you be consistently utilizing this ratio when constructing your own portfolio? 

The PEG ratio divides the P/E ratio by expected earnings-per-share growth.  Attractively valued stocks are generally deemed to be those with a PEG ratio less than 1.0.  By looking just at the S&P 500 we can see where this logic comes from.  The S&P 500 has historically grown earnings at rate of 6-8% depending on the starting point.  The Index has averaged a price-to-earnings ratio of approximately 16x over its long history.  Thus, on average the market’s PEG ratio has been around 2x or even slightly higher.  Therefore, it would seem logical that an individual stock with a PEG ratio of less than one is attractively valued and should be well positioned to outperform in the long term.

Past Failures

One stock that always jumps out when I think about PEG ratios is that of Stryker (NYSE: SYK).  Stryker is a one the leading medical device companies in the world thanks years of consistently high growth.  During the middle of the last decade the company was consistently generating earnings-per-share growth in excess of 20%.  It seemed like every annual update made sure to highlight that earnings growth would exceed 20% and as growth slowed they tried to hold this bar for as long as possible.  The chart below shows Stryker’s historical price-to-earnings ratio.

SYK PE Ratio TTM data by YCharts

The company finished 2007 with EPS growth of 29% and the PEG ratio was oscillating around 1x and would sometimes fall fractionally below the magical 1.0 level.  Once the company’s 20% EPS growth threshold was breached in 2008, along with a massive bear market, the multiple was in free fall.  It would be easy for an investor in 2007 to be wooed by a 30% growth rate and a PEG ratio of 1.0x in a defensive industry with enormous secular tailwinds.    Between the start of 2008 and the end of 2012 shareholders in Stryker would realize a -22% total return compared to +8% for the S&P 500.  What happened?  Earnings growth entered a permanent decline.  Even after the global collapse earnings growth has been subdued with little signs of reacceleration toward past glory days. 

Is a 40x price-to-earnings multiple justified if a company just finished its second consecutive year of 50% earnings per share growth?  And if the multiple falls to 20x as earnings growth tops 50% for the third straight year would you have one the greatest investment opportunities in a generation?  According to PEG analysis and several professional investors- YES. 

This was the situation in late 2007 as Garmin (NASDAQ: GRMN) shares soared above $100 as investors envisioned the company’s navigation devices in millions of consumer products.  The company would then report stellar 2007 growth numbers despite the fact that shares were now trading around $50.  The PEG ratio would drop below 0.5x and it was becoming clear that lower earnings growth was inevitable.  Surely a PEG ratio of 0.3x fully embeds all the bearishness that recently cut the stock in half?  Well, more than four years later the stock has failed to break above the $50 level and currently trades at less than $40 per share.  Garmin was a rare bird indeed going straight from 60% EPS growth to negative growth the following year- and several years thereafter.  The $3.79 EPS number achieved in 2007 still remains the high-water mark.

Sustainability of Earnings Growth

There are plenty of stocks with a PEG ratio under 1.0 and some will turn out to be winners and some will be notorious losers.  The tool has a good theoretical basis, but the key ingredient is future earnings growth.  Suffice it to say, investors are awful at CONSISTENTLY forecasting earnings growth.  Get the earnings growth wrong and the PEG game becomes impossible to beat.

The other key ingredient is the starting point of the P/E ratio.  A PEG ratio of 1x on a stock with a 10x P/E ratio has much less embedded risk than a stock with a similar PEG ratio that accompanies a multiple of 50x. 

The Current Environment

The market appears to be quite attractively valued  given the suppressed P/E ratios on the vast majority of mid-cap and large-cap U.S. equities.  One company that seems a bit iffy from a PEG standpoint is AutoZone (NYSE: AZO).  The automotive parts retailer was one of the great stocks of the past decade.  While the S&P 500 has returned less than 2% annually during the past TWELVE years, AutoZone has returned 22% annually!  The stock is reasonably valued at 15x earnings with forecasted EPS growth of 17% in 2013.  PEG alert!  The company was able to grow EPS throughout The Global Recession and peaked out at 30% EPS growth in 2011.  They achieved 20% growth in 2012 and the forecast is for 17% in 2013.  At first blush there appears to be a bit of anchoring to prior growth levels and downside risk exist.   Same-store-sales are in a clear downtrend as evidenced by the chart below that shows quarterly same-store-sales.  And with over 5,000 locations, investors shouldn’t expect much from new store growth. Also, low interest rates should start to fuel increased new car sales and put a dent into the extremely elevated average auto age.

 

It is entirely possible that earnings growth falls short of expectations and that the stock underperforms.  Investors can at least take solace in the fact that the starting multiple is only 15x and the notion that it is very unlikely earnings growth turns negative in the next several years given pent-up demand from an aging auto fleet.  But consistently slower EPS growth would be a clear headwind to share outperformance.

Investor’s might find BorgWarner (NYSE: BWA) more appealing within the auto complex.  The leading producer of automotive engine solutions has an identical P/E ratio at 15x, but is only forecasted to grow that number 10% in the coming year.  However, there appears to be more upside and sustainability to this growth as regulators continue to push the boundaries on fuel efficiency.  BorgWarner also has tremendous emerging market opportunities in the coming decade that make it plausible current expectations are conservative.

The Foolish Bottom Line

Playing the PEG game blindly can be dangerous and fool investors to the true underlying risk they are taking.  The ratio really fails when trying to justify richly priced equities with current elevated growth rates.  Often times these growth rates are unsustainable and the stocks can suffer disastrous outcomes when growth slows- even if it remains well above the average market growth rate.  To effectively beat the PEG game, investors need to double check two things.  First, the starting P/E ratio must be reasonable.  The word reasonable is subjective, but I would put the upper limit at 25x and this is probably reaching a bit.  Secondly, thorough due diligence is required to ensure a high conviction that the company can meet or beat implied growth rates. 


market8 has no position in any stocks mentioned. The Motley Fool recommends BorgWarner. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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