VALUE INVESTING
Putting A Peg On Value

By Stephen Bland (TMFPyad)
September 23, 2005

In Value Investor I looked recently at the PEG concept when selecting value trading shares. In July's issue it led me to select the large mining company BHP Billiton (LSE: BLT). The Value Investor scorecard buy price is 742p and the price is now 850p. A gain of 14.5% and on top of that, a dividend of 7.9p has been paid to give a total return of 15.6% to date. And note that this is from a major FTSE100 company. Bigger is better when it comes to value.

Some years back, I think it was Jim Slater who coined the idea of the PEG, being shorthand for Price/Earnings ratio divided by earnings per share growth. I doubt that it was a wholly new idea, more likely a name put to something many investors were probably doing anyway.

So what is the PEG? It stands for Price/Earnings ratio divided by the percentage growth in earnings.

The P/E ratio is probably the single most popular method of comparing and ranking shares. What it reveals is the number of years of annual earnings per share contained in the share price. So a P/E of 15 for a share priced at 90p means that the share price is 15 times the earnings per share of 6p. Clearly, as the share price fluctuates, the P/E will move in direct proportion as long as the same eps is being considered.

Now on its own this ratio doesn't mean anything. Is 15 good or bad, high or low? The question can't be answered by considering this share in isolation. It makes sense only in comparison with others. It would be high against other P/Es of 8 but low against some at 25. There are a number of ways the ratio can be used but it is only in a comparative sense that the information becomes meaningful. For value players, generally the lower the relative P/E the better.

Another common feature of value is the search for forecast rising eps. My original pyad approach looks for this figure to increase at a decent amount above the historical eps in order to create an outer, ie. a reason for the price to move up. The idea is that rising eps has to create a rise in the share price sooner or later, because the P/E, already low from my selection procedure, would become too low if the expected eps rise materialised.

But one limitation of P/E generally is that it pays no heed to the changes in the eps pattern. Two shares on a similar P/E might not be as similar as the ratio suggests. If the first has static eps forecast and the second has a big rise forecast then by next year the latter's P/E will have fallen compared with the first. The likelihood is then that the market may then increase the price of the second share to compensate, so it could be a much better investment on the face of it.

What the PEG does is take account of this by comparing a P/E with the growth rates of eps. Like P/E it is meaningful only by comparison with other shares. The lower the PEG the more attractive the share. In the above example if the eps is expected to move up from 6p to 8p, an increase of 33%, then the PEG would be 15/33 being 0.45. Another share on the same P/E whose eps was forecast to increase by 10% would be on a PEG of 1.5, much dearer than the former.

The ideal mix of these ratios for value players is a low P/E and a low PEG. This means that not only is the share already desirably cheap on P/E grounds, but also you are getting the important eps increase cheap too. Growth investors might use the PEG with a high P/E and not worry too much about it, but that would not be the value player's style.

I'll be honest and say that the PEG is not a ratio that I had considered consciously in the past. However, my deep value pyad approach looked for rising earnings per share as an outer, so it was, without having that name, built into my style in effect. But I never actually measured the PEGs of my shares as a value feature.

The reason I've come to it now for Value Investor readers is that attractive deep value shares are hardly around at present. So I've modified the approach to using PEGs as part of the value search in some cases. Note that the ratio is best used with large caps having many analysts forecasting, because the figures need to be as reliable as possible. Forecasts are always questionable but the more the better.

As market conditions change, I alter to some extent the mix of value methods I use to locate suitable shares. They're all based upon the old ideas of some combination of attractive fundamental ratios of various kinds so that the principal concept of finding cheap yet attractive plays remains at the root of the concept. I'm not going to abandon that basic instinct.

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The latest Value Investor scorecard, dated 14 Sept 2005, showed an average gain for all shares picked to date of 10.5%.