Skip to main content

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

Comments

Post a Comment

Popular posts from this blog

Sound Advice: July 16, 2025

Fixed annuities are poor investments Fixed annuities are often criticized as poor investments for several reasons, despite their reputation for providing stable, predictable income.  Here are the key drawbacks and concerns:   High Fees and Commissions Internal Fees:  Fixed annuities can carry a range of fees, including administrative charges, mortality expense risk fees, and rider fees. These can add up to 2%–4% per year, significantly eroding returns over time. Commissions:  Sales agents and financial advisors often receive high commissions for selling annuities—sometimes as much as 5%–8% of the invested amount. This creates a financial incentive for advisers to recommend them, even when they may not be the best fit for the client. Comparison to Other Investments:  Mutual funds and ETFs typically have much lower fees and commissions, making them more cost-effective for long-term growth. Limited Growth a...
Post a Comment
Read more

Sound Advice: October 8, 2025

How many investors have outperformed the stock market over the last 20 years? Very few investors have outperformed the stock market over the past 20 years.   Data shows that only about 6% to 8% of actively managed equity funds in the U.S. beat the market over this period, with the vast majority—over 90%—underperforming the S&P 500 or equivalent broad indexes. Percentage of Investors Beating the Market Only 8% of equity funds investing in large companies managed to outperform the market over a recent 20-year span. About 94% of all domestic funds underperformed the S&P 1500 Composite Index from 2005-2024. Over shorter timeframes (5-10 years), typically fewer than 15-20% of fund managers beat the S&P 500, and performance persistence is rare. Why It Is Rare The S&P 500’s high returns have proven immensely difficult to beat, especially as indexing has become popular and markets have ...
Post a Comment
Read more

Sound Advice: January 15, 2025

Why investors shouldn't pay attention to Wall Street forecasts   Investors shouldn't pay attention to Wall Street forecasts for several compelling reasons: Poor accuracy Wall Street forecasts have a terrible track record of accuracy. Studies show that their predictions are often no better than random chance, with accuracy rates as low as 47%   Some prominent analysts even perform worse, with accuracy ratings as low as 35% Consistent overestimation Analysts consistently overestimate earnings growth, predicting 10-12%                 annual growth when the reality is closer to 6%.   This overoptimism can                 lead investors to make overly aggressive bets in the market. Inability to predict unpredictable events The stock market is influenced by numerous unpredictable factors, including geopolitical events, technological changes, and company-specific news.   Anal...
Post a Comment
Read more