PEG ratio gaining in popularity against the P/E, but beware of its flaws

A common method used to establish the best value for money when comparing shares in different companies is to look at their respective price earnings ratios. This ratio is defined as the current market value of a share in cents divided by its earnings per share for a year in cents.

Other things being equal, the lowest price earnings ratio indicates the best value for money. But, of course, other things are never equal.

One problem with the price earnings ratio as published in newspapers is that the numerator in this ratio, being the market value of the share, is up-to-date, as the market is always looking forward, while the denominator, the earnings per share figure, is not. It could relate to a period that started some 27 months earlier and finished some 15 months earlier. That is the position shortly before a new annual report is released.

For this reason brokers and analysts often use a forecast earnings per share figure when calculating a PE ratio. This is all well and good, but it turns a seemingly objective yardstick into a subjective one. Different brokers will make different estimates, to the confusion of investors.

In an attempt to overcome this weakness some investors have turned to a different yardstick, namely, the PEG ratio. This is defined as the price earnings ratio of a share divided by the annual growth in earnings per share. Once again, other things being equal, the lowest PEG ratio indicates the best value for money.

To illustrate: If company A has a price earnings ratio of 40 and an annual growth rate for its eps of 20 per cent then its PEG ratio will be 40 divided by 20 or 2. If company B has a price earnings ratio of 12 and an annual growth rate for its eps of 10 per cent then its PEG ratio will be 12 divided by 10 or 1.2, suggesting that it might be the better buy.

But this approach presents some problems. For one thing, the PEG ratio has no mathematical basis and sometimes leads to nonsensical results. For another, it leaves open the question of how to define the annual growth rate. Should one use a historical rate or a projected rate? If a historical rate is to be used, should it be based on one year or three years or five years or something else?

It would seem more logical to base such investment decisions on a different figure, namely, the earnings yield plus the annual growth in earnings per share. The earnings yield is defined as the earnings per share for a year in cents divided by its current market value in cents, expressed as a percentage.

The best value for money would then be in the stock with the highest figure.

Theoretically this represents the increase in investor wealth over a 12-month period. The portion of earnings, which is paid out by way of dividends, enriches investors directly. The portion, which is retained within the company, feeds into its market value and thus enriches investors indirectly. The annual growth in earnings per share would normally lead to a proportionate increase in the market value of the share, once again other things being equal.

It is instructive to compare the two measures discussed above in a representative sample of 10 well-known stocks, as set out in the table below. The growth rate was in the main based on five-year figures, although this period was an arbitrary choice. A different period would have given a different numerical outcome.

It is interesting to note that both methods for the stocks in the sample (in the table) lead to remarkably similar results in their rankings – for example, the ranks for the best two stocks and the worst three stocks are the same, thus possibly lending some credibility to the unmathematical PEG ratio. However, the numbers in the table should not be regarded as investment recommendations.