COMMENT

Looking For Growth Share Bargains, Part 1

By Ed Bowsher (TMFArkle)
April 20, 2006

Do you rely on the price to earnings (P/E) ratio too much? I know I sometimes do. When I'm taking a quick look at a company, it's all too easy to say "Associated Widgets is on a P/E of 5 and is therefore cheap while Sexy Software looks pricey on a P/E of 25."

I've delivered my verdict on both companies in two minutes. But in reality I've barely scratched the surface of either business. Sexy Software looks expensive at first glance but the P/E ratio won't tell you that Sexy is about to launch a new world-beating product that will treble the company's profits.

Using the Price to Earnings/Growth ratio (PEG) can help you see a bigger picture (although far from the complete picture). That's because it helps you to take rising profits into account.

This is how it's calculated:

      Price to Earnings Ratio
-------------------------------------
Forecast Growth in Earnings Per Share 

ARM Holdings (LSE: ARM), for example, is expected to generate earnings per share of 6.26p in 2007. At 133.25p, the company's forward P/E ratio is 21.3, so with the market trading on a P/E of 14 or so the microchip designer looks expensive using the P/E ratio on its own.

However, the 2007 earnings forecast is 21.8% higher than the forecast for 2006. So let's calculate ARM's PEG ratio:

21.3  (forward P/E ratio)
--------------------------------  = 0.98
21.8  (forecast earnings growth)

Fans of the PEG ratio reckon that a PEG below 1 is cheap, so on that basis ARM looks mildly attractive.

But there are lots of caveats. For starters, can I trust the analysts' forecasts? And attractive PEG ratios can hide numerous sins such as high levels of debt or poor cash generation.

What's more, my original calculations only looked at ARM's predicted earnings growth for 2007, which in isolation may not reflect the company's true growth rate. Indeed, ARM's growth for 2006 is projected to be 141% and therefore over the next two years, the compound estimated average growth rate is 71% per annum.

So I can recalculate the PEG ratio as follows:

21.1 (forward P/E ratio)
-----------------------------  =  0.30
71 (forecast earnings growth)

This gives a PEG ratio of 0.3. On that basis, ARM looks like a cracking bargain!

So now I'm confused. I'm not sure whether ARM is cheap or not. Clearly I need to do some more digging...

Nevertheless using both the PEG and the P/E ratio has told me more about ARM than just the P/E on its own. The PEG has got me thinking about ARM's growth potential and helped me to try and value that potential. I reckon it can be a useful first step if you're looking for cheap growth shares.

In part 2, I'll look at three attractive shares with low PEG ratios.

For more on ARM and PEGs, you can read:

"Encouraging Results From ARM" by Padraig O'Hannelly
"Is The Zulu Principle Suitable For Long-Term Investors" by Maynard Paton
"Four Zulu Principle Shares" by Maynard Paton