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Sound Advice: May 17, 2023

Say hello to PEG

No, she’s not a new neighbor.  PEG is the acronym for Price-to-Earnings Growth Ratio.  Although stock analysts tend to litter their conversations with shop talk such as PE (Price-Earnings Ratio), ROI (Return on Investment), and Debt-to-Equity Ratio, PEG may well be more telling about the level of stock valuations.

The process of evaluating stocks begins with evaluations of the underlying companies.  This includes income statements (a.k.a., profit and loss statements) and balance sheets.

Concerns about income statements focus on the trends in earnings, which include profit margins, tax rates, and net income.  What’s important here are the trends over time.  Are margins rising or at least holding their own? Are tax rates following a consistent pattern or have there been interim aberrations? And is the bottom line expanding?

Flat or rising margins are good.  Level tax rates are also OK, but if there’s been an outlier, what would have been the impact on net income?  If a temporarily lower tax rate had been the reason for higher earnings, the analyst would adjust accordingly and plot a normalized level to view a more meaningful comparison.

Assuming consistent margins and rising net income, the next step would be to view the balance sheet to ensure that current debts are comfortably covered by available cash.  If so, it’s time to check the mixture of long-term debt and stockholders’ equity.  A simple rule of thumb would be no more than one-third debt and at least two-thirds equity.

If the company’s numbers pass the tests, it’s on to stock valuations.  The measure most commonly used for this purpose is the PE ratio, which is the stock’s market price divided by the earnings per share (net income divided by the number of shares).

Typically, the higher the prospective rate of future growth, the higher the PE.  But there’s a considerable difference between high and stratospheric.  That’s where PEG comes in.

PEG is calculated by dividing the PE by the prospective growth rate over the next few years.  (The prospective growth rate can be found on a number of websites, including Yahoo Finance and MSN Money.) So if the PE is 40 and the growth rate is 20% a year, the PEG would be 2.0, close to the upper end of a reasonable range. 

As one might suspect, there are more than a few situations in which the PE is beyond the border of the absurd.  So it’s always a good idea to check with PEG before venturing into FantasyLand.

 

N. Russell Wayne, CFPÒ

Any questions?  Please contact me at nrwayne@soundasset.com

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