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Aswath Damodaran
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PEG Ratios
Aswath Damodaran
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Investment Strategies that compare PE to the
expected growth rate
n
If we assume that all firms within a sector have similar growth rates
and risk, a strategy of picking the lowest PE ratio stock in each sector
will yield undervalued stocks.
n
Portfolio managers and analysts sometimes compare PE ratios to the
expected growth rate to identify under and overvalued stocks.
•
In the simplest form of this approach, firms with PE ratios less than their
expected growth rate are viewed as undervalued.
•
In its more general form, the ratio of PE ratio to growth is used as a
measure of relative value.
Aswath Damodaran
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Problems with comparing PE ratios to expected
growth
n
In its simple form, there is no basis for believing that a firm is
undervalued just because it has a PE ratio less than expected growth.
n
This relationship may be consistent with a fairly valued or even an
overvalued firm, if interest rates are high, or if a firm is high risk.
n
As interest rate decrease (increase), fewer (more) stocks will emerge as
undervalued using this approach.
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PE Ratio versus Growth  The Effect of Interest
rates:
Average Risk firm with 25% growth for 5 years; 8% thereafter
Figure 14.2: PE Ratios and T.Bond Rates
0
5
10
15
20
25
30
35
40
45
5%
6%
7%
8%
9%
10%
T.Bond Rate
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PE Ratios Less Than The Expected Growth Rate
n
In September 2001,
•
33% of firms had PE ratios lower than the expected 5year growth rate
•
67% of firms had PE ratios higher than the expected 5year growth rate
n
In comparison,
•
38.1% of firms had PE ratios less than the expected 5year growth rate in
September 1991
•
65.3% of firm had PE ratios less than the expected 5year growth rate in
1981.
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PEG Ratio: Definition
n
The PEG ratio is the ratio of price earnings to expected growth in
earnings per share.
PEG =
PE / Expected Growth Rate in Earnings
n
Definitional tests:
•
Is the growth rate used to compute the PEG ratio
– on the same base? (base year EPS)
– over the same period?(2 years, 5 years)
– from the same source? (analyst projections, consensus estimates.
.)
•
Is the earnings used to compute the PE ratio consistent with the growth
rate estimate?
– No double counting: If the estimate of growth in earnings per share is from the
current year, it would be a mistake to use forward EPS in computing PE
– If looking at foreign stocks or ADRs, is the earnings used for the PE ratio
consistent with the growth rate estimate? (US analysts use the ADR EPS)
Aswath Damodaran
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PEG Ratio: Distribution
Price/ Expected Growth RAte
400
300
200
100
0
Std. Dev = 1.05
Mean = 1.55
N = 2084.00
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PEG Ratios: The Beverage Sector
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This note was uploaded on 01/29/2012 for the course FIN 6000 taught by Professor Banko during the Fall '11 term at University of Florida.
 Fall '11
 BANKO

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