Valuing stocks using the PEG (Price to Earnings Growth rate) ratio is foolish

Of all measures to value stocks, the PEG (Price to Earnings Growth rate) ratio is one of the most foolish. It should be completely ignored.

A PE (Price to Earnings) ratio is based on what a company made in revenues and earnings the previous year. The theory is that customer habits are predictable, and what you sold in revenue and earned in profit last year, you can at least repeat that this year. This sometimes fails, but works okay as a company gets bigger, because buyers have patterns; and if buyers bought an average of X dollars worth of stuff from the company last year, they are likely to buy X worth of stuff this year as well. It is a fact that most businesses are based on repeat customers, and the PE ratio captures that well. However, the company needs to be big if it is a consumer company (e.g. at least 10 billion dollars revenue per year in the US) for you to be able to say this with confidence, or should have a subscription model or a contractual purchase model (predictable revenue streams), where barriers to switching are high. If this is not the case, what you earned last year (or made in revenues) has nothing to do with what you will earn this year, because your revenues can be very different. Because buyer behavior is not 100% predictable, they are not locked in, and you cant extrapolate what happened last year to this year.

With the PEG ratio you are bringing in the growth rate (of revenues or earnings) as another variable.Predicting the revenues and earnings of a company is hard enough when thought of year over year, and only if a company gets quite big or has a subscription or contractual model you can do so; but growth rates CANNOT be predicted or extrapolated at all. That a company grew at 15% for the last 3 years year-over-year, doesn't mean that the next year it will grow 15%. Similarly, a company which didn't grow at all for the last 3 years doesn't mean that it won't grow this year. Growth rates are very volatile, and are not based in the logic of repeat customers, predictable revenue streams, etc. which the actual revenues and earnings are based on. Mathematically speaking, the growth rate is the derivative of earnings or revenues with time, and the pattern of this derivative is highly unpredictable, and has nothing to do with the predictability of the original revenue or earnings.

If you own a company, with great difficulty you are able to predict its revenues from year to year. The growth rates of revenues (and hence profits)-is completely unpredictable. Some years you have high growth rates, other years very low growth rates. Previous low growth rates do not extend to lower growth rates in the future, nor do historical high growth rates extend to high growth rates in the future. The PEG ratio is a completely idiotic invention in evaluating stocks. Please stop using it.