Valuing stocks using the PEG (Price to Earnings Growth rate) ratio is not a good idea

Of all measures to value stocks, the PEG (Price to Earnings Growth rate) ratio is one of the most incorrect. 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 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 (or this could stretch out over several years-they may purchase X dollars worth of stuff every 5 years, and since there are many customers doing this in a staggered fashion, you can still predict revenues and earnings every year). Most businesses are based on repeat customers, and the PE ratio captures that well-the predictability of yearly revenues and profits is nothing but a predictability of repeat customers. However, the company needs to be quite big (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 little 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 can't 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,  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.

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.

No comments:

Post a Comment