December 22, 2023
Bruce Kaser of Cabot Wealth NETWORK wrote a highly informative article on the PEG ratio that is worthy of consideration by all students of the market.
Here is a summary of the article:
- PEG Ratio Overview:
- Frequently used but can lead to wildly incorrect valuations.
- Compares a stock’s P/E multiple to its long-term earnings growth rate.
- Amazon vs. Verizon illustrates how PEG ratios can yield misleading comparisons:
- Amazon (AMZN): P/E of 41x, projected growth at 29%, resulting in a PEG ratio of 1.4x.
- Verizon (VZ): P/E of 8x, slow growth at just over 1%, resulting in a PEG ratio of nearly 6x.
- Origin and Popularization:
- Popularized by Peter Lynch, suggesting a PEG ratio of 1.0x represents fair value; however, Lynch didn’t solely rely on PEG and had a comprehensive evaluation approach.
- Flaws of PEG Ratio:
- This can lead to nonsensical conclusions, as seen with Verizon and Conagra.
- Unreliable for certain sectors (financials, energy, basic materials, real estate, utilities) due to unique profit and growth traits.
- Assumes all growth has the same value, which may not be true.
- Problems with Growth Estimates:
- Growth estimates can change rapidly, impacting PEG ratio reliability.
- Assumes fast-growing companies can sustain the pace indefinitely, which is often untrue.
- Pandemic-era examples like Zoom Video Communications highlight the potential pitfalls of relying on PEG ratios.