Peg - PEG Ratios Aswath Damodaran Aswath Damodaran 1 Investment Strategies that compare PE to the expected growth rate n n If we assume that all

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Aswath Damodaran 1 PEG Ratios Aswath Damodaran
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Aswath Damodaran 2 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.
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Aswath Damodaran 3 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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Aswath Damodaran 4 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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Aswath Damodaran 5 PE Ratios Less Than The Expected Growth Rate n In September 2001, 33% of firms had PE ratios lower than the expected 5-year growth rate 67% of firms had PE ratios higher than the expected 5-year growth rate n In comparison, 38.1% of firms had PE ratios less than the expected 5-year growth rate in September 1991 65.3% of firm had PE ratios less than the expected 5-year growth rate in 1981.
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Aswath Damodaran 6 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)
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Aswath Damodaran 7 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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Aswath Damodaran 8 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.

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Peg - PEG Ratios Aswath Damodaran Aswath Damodaran 1 Investment Strategies that compare PE to the expected growth rate n n If we assume that all

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