What's the thinking behind the PEG ratio, and -- more importantly -- does it work?
When it comes to investing, growth and value are often regarded as polar opposites, but not by everybody. To quote Warren Buffett:
"Growth and value are indistinguishable; growth is part of the value equation".
With that in mind, many of us are looking for growth at a reasonable price, or 'GARP'.
The most common tool used in this search is the PEG ratio. Defined as the PE ratio divided by the growth rate (in percent), the PEG gives us a measure that combines the growth and valuation elements -- the smaller the PEG, the 'cheaper' the growth.
While the PEG was popularised by Jim Slater in The Zulu Principle (1992), and Beyond The Zulu Principle (1996), the idea had been investigated previously in a study by D.J. Peters in 1991. This study indicated that the PEG had been a significant indicator of performance for growth stocks in the US in the 1980s.
One key difference between the commonly accepted measure (i.e. Slater's), and Peters' definition, is that Slater takes the expected growth rate and future PE, whereas Peters uses the historical PE. In the case of a growth stocks, this can make quite a difference. My preference is to use Peters' version of the PEG, as I dislike the idea of factoring expected growth into both parts of the formula -- effectively double-counting the growth.
And that's the thing about the PEG -- we can muck about with it however we want as there is little or no theoretical basis to it. While Gordon's Dividend Discount Model may have limited practical application for most investors, the logic behind it is very clear and it enables us to calculate theoretical PE's for various values of discount rates and growth rates. The PEG has been shown to be inconsistent with that model.
In its essence the PEG is just a rule of thumb -- a convenient shortcut. And there's nothing magic about using a PEG value of 1.0 as a cut-off point either. I use the PEG as a crude way to select and rank potential investments, pending further investigation.
Just for fun, I did a 60-second study of my own, back-testing the PEG over the past 5 years using Digitallook's MarketStars facility. This showed shares with a PEG below 1.0 outperforming those with a PEG greater than 1, especially for shares with a market capitalisation below £100m. It doesn't prove anything, but neither does it surprise me.
More than a decade on, the PEG remains a simple and useful tool in the quest for GARP. It won't generate any Nobel Prize winners, but it may help generate some profits.
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> Is The Zulu Principle Suitable For Long-Term Investors?
> Long-Term Lessons From The Zulu Principle
> What Value Investing Isn't
