The PEG Ratio: It’s Better To Calculate Your Own

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

I believe the PEG ratio is by far the most misleading stock valuation method available today. Before I explain the reason for this, though, it is important to understand what the actual definition of the PEG ratio is.

The PEG ratio is defined by Investopedia as:

A stock's price-to-earnings ratio divided by the growth rate of its earnings for a specified time period. The price/earnings to growth (PEG) ratio is used to determine a stock's value while taking the company's earnings growth into account, and is considered to provide a more complete picture than the P/E ratio. While a high P/E ratio may make a stock look like a good buy, factoring in the company's growth rate to get the stock's PEG ratio can tell a different story. The lower the PEG ratio, the more the stock may be undervalued given its earnings performance. The calculation is as follows:

P/E ratio/Annual EPS Growth = PEG

Usually the growth rate used in this calculation is the predicted EPS growth rate for next year.

However, as the offical definiation does not specify the period of growth that should be used there are many different variations to the ratio, which results in every website having its own way of calculating the ratio. For example:

YCHARTS - uses a P/E ratio based on the figures of the past 12 months and uses earnings growth of the 12 months before that.

Yahoo! Finance - uses a 5yr predicted earnings growth rate – highly unstable because not even the most experienced and educated analyst can predict business conditions five years out from now.

Finviz - states that it uses the P/E ratio divided by the annual growth rate. Although the company does not specifically state which growth rates it uses.

Extremely misleading

For an example of how misleading these ratios can be, I am going to look at Coca-Cola (NYSE: KO). Throughout the rest of the article I will calculate my PEG ratio based on the forward P/E and EPS growth rates.

The Coca-Cola Company

Ratios and price used as an example, correct as of Jan. 25, 2013

Price $37.1
2013 predicted EPS 2.2
2013 predicted EPS growth 9.5%
Forward P/E  16.8
PEG 1.8
Financial Website PEG
Yahoo! Finance 2.3
Finviz 2.4
Bloomberg 2.42
YCHARTS N/A (EPS fell during the last 12 months in comparison to the same period last year so it is not possible to produce a ratio. The last available ratio was in sept. 2011 this was 0.2!)

The difference in these ratios is astronomic.  Unfortunately, for an investor who depends on reliable data the PEG ratio becomes useless due to the many different methods there are of calculating it.

To further illustrate my point, these are some of the most volatile PEG ratios on the market right now.

Ford Motor Company (NYSE: F)

Ratios and price used as an example, correct as of Jan. 25, 2013.

Price $13.9
2013 predicted EPS 1.5
2013 predicted EPS growth -66 % (fall)
Forward P/E  9.5
PEG
N/A (due to the negative growth rate it is impossible to calculate a PEG ratio)
Financial Website PEG
Yahoo! Finance 1.4
Finviz 0.5
Bloomberg 1
YCHARTS 0.02

An investor looking to invest on the basis of a low PEG ratio would have trouble with Ford. Technically a negative growth rate cannot be used to formulate a PEG ratio, as the number would be negative. However, most finance websites still give it a go. 

AIG (NYSE: AIG)

Ratios and price used as an example, correct as of Jan. 25, 2013.

Price $36.6 
2013 predicted EPS  3.5
2013 predicted EPS growth  -75 % (fall)
Forward P/E   10.4
PEG N/A (due to the negative growth rate it is impossible to calculate a PEG ratio)

Financial Website PEG
Yahoo! Finance   0.5
Finviz  0.1
Bloomberg  0.7
YCHARTS 0.2

I use historic ratios here, as AIG has grown quickly over the past few years and quarters. The ratios based on historic growth rates are showing ratios below 1, while my ratio - calculated on next year’s growth rate - is negative, and therefore not possible to use.

Conclusion

In conclusion, the PEG ratio can be a useful tool when combined with a complete fundamental analysis of the underlying business and consideration of all the factors involved. Keep in mind, though, that it turns out it is usually better for an investor to calculate their own ratios based on their own research to prevent confusion.

A historic PEG ratio could be useful in establishing how undervalued the company is compared to historic growth rates; however, this will not help with establishing how profitable the business will be in the future. On the other hand, using a forward PEG ratio can be speculative, as you are speculating on the predicted results of the company. From these two points it is hard to draw a definitive conclusion on whether or not the PEG ratio is a useful tool for investment.

But one thing is for certain: unless calculated personally, the PEG ratio is extremely misleading.


RupertHargreav has no position in any stocks mentioned. The Motley Fool recommends American International Group, Coca-Cola, and Ford. The Motley Fool owns shares of American International Group and Ford and has the following options: Long Jan 2014 $25 Calls on American International Group. 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!

blog comments powered by Disqus

Compare Brokers

Fool Disclosure