Price-Eanings Growth Factor (PEG)

As we have seen, the PER of a company is of limited use as an investment tool because it only gives a one-dimensional measure of the price of a share relative to future earnings per share; it does not show if that price represents good or bad value.

The Price-Earnings Growth factor is a much more sophisticated measure because it relates the PER of a company to its future earnings growth rate and gives a better indication of value. Everyone knows that great growth shares merit a high PER, but the PEG helps you to determine how high and whether or not the shares are a buy or are losing touch with reality.

The PEG factor is calculated by dividing the prospective price-earnings ratio of a share by the estimated future growth rate in earnings per share. In May 1998, for example, the average UK share had a prospective multiple of 15 and was looking forward to increased year-ahead earnings growth of 8%. The average prospective PEG was therefore 1.9 (15/8). Alow PEG value indicates that investors are paying a relatively low price for future earnings growth; a high PEG indicates that the shares are relatively more expensive.

A PEG below the average is superficially attractive, but the market is at a high level so when searching for bargains subscribers should be focusing on shares with PEGs of below one.

Over the long term, it has paid to buy the market on a PEG of one or below. Because of this, a company growing at 15% per annum would obviously be very appealing on a multiple of 15 or less. At a growth rate of 20% per annum, a multiple of 20 would also be good value.

Because the prospective PEG is a dynamic measure, it is always calculated by apportioning figures from the current and following financial periods using estimates in just the same way as for prospective PERs and normalised prospective EPS.

When a PEG is based on the consensus forecast for the next twelve months, this is indicated by the letters 'pr' in brackets. If there is no forecast, historic figures based on the last twelve months are used.

As already explained, the method of calculation used in REFS ensures that the company entries are as up-to-date and dynamic as possible.

How the PEG method works is best illustrated by the hypothetical example of a company growing at 25% per annum on a prospective PER of 16. This would give a very attractive PEG of 0.64. When the forecast becomes a reality, and next year's projected growth of a further 25% becomes the focus of attention, the shares then enjoy a double benefit. First,
from the higher earnings figure used in analysts' calculations and, second, from a change in status as the market accepts that a higher PER is justified. At an early stage in the company's development, the PER might rise from 16 to 20, so the earnings gain of 25% would be compounded by a further 25% increase from the status change, resulting in a total gain of 56.25%.

To illustrate the dramatic impact this can have on the share price, imagine that before the announcement of results, expected earnings of 10p per share and a PER of 16 implied a price of 160p. After the announcement, the higher PER of 20 on forecast earnings of 12.5p would result in a share price of 250p.

In addition to helping to maximise the upside potential from a share, the PEG can also be used as a defensive measure. A company with a below average PEG is obviously less vulnerable (all other things being equal) than a share with an above average PEG. It is therefore worthwhile periodically calculating the average PEG of a growth portfolio to evaluate how defensive it would be in a bearish climate.

There are a number of important caveats to bear in mind:-

1. The PEG factor is designed especially to measure growth stocks. It does not work well for recovery stocks, cyclicals and asset situations.
   
   Frequently, it is difficult to distinguish between recovery and growth. For the PEG measure to work at its best, the figures should be based on sustainable growth or the expectation of it.
   
   Coming out of a recession, almost all companies are recovering to a greater or lesser extent. However, those with a record of consistent growth over the previous four years are very different from companies which have suffered from a major setback and are trying to recover to their former profit levels.
   
   REFS has classified companies as growth stocks and awarded them a PEG only if they have at least four years of consecutive earnings per share growth. This can be either in the last four years if there is no forecast, or a combination of past growth (usually two years) and future forecast growth (usually the current year and the one ahead). The REFS approach is dynamic as it allows companies that are benefiting from a recent management change to qualify for a PEG. Aquick visual impression can also be obtained from the graph, which clearly shows whether or not a company is a growth share under
   this definition.
   
2. A low PEG factor is, by itself, not a sufficient reason to buy a share. Although compromises are often necessary, the selected company should ideally have a competitive advantage, strong cash flow, insignificant debt and positive news-flow.
   
3. The PEG method of selecting growth stocks works at high levels of growth, but the dangers of high PERs are much greater. For example, a share growing reliably at 30% per annum would, in today's markets, merit a PER of at least 30. Growth at such a high rate is not, however, usually sustainable, so the downside risk is increased. The effects of a change in news-flow, even from excellent to reasonably good, could have a disastrous effect on a stock with a high PER (especially if it has no dividend yield). The PEG measure works at its best with companies which have earnings growing at 15 - 25% per annum, with PERs within five points either way of the average. Based on the average prospective PER of 15, the best and safest results would be obtained with growth stocks with PERs in the 12 - 20 bracket.
   
4. PEGs are calculated on normalised earnings. The earnings forecasts are based on consensus figures obtained from a very large number of UK brokers. These figures are updated monthly, but the reliability of their consensus forecast (and therefore the PEG) is much enhanced if a large number of brokers are covering the company. The forecast is
   also more reliable if there is a small difference between individual estimates and the overall consensus figure.
   
5. Brokers' estimates of future EPS may be based on the assumption that the company will have a below-normal tax charge. In some cases it may enjoy this benefit for several years to come; in others EPS may suffer a setback as the tax charge rises to a normal level.

As with other investment criteria, the PEG cannot be considered in isolation. However, it is the single financial statistic that gives an instant fix on whether growth shares appear to be cheap or dear.

The column of moons shows the PEG relative to the market and the company's sector. A full black moon shows a very low PEG, a half-filled moon an average one and a blank moon a very high one.