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Author: RichSK Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 2003  
Subject: Re: PEG intuition Date: 3/5/1999 10:45 AM
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"Obviously, a successful company is worth much more than that. One must take into account future profits... and that is why share price and book value are never in lock step. The more a company is expected to earn in the future, the higher price-to-book ratio it can claim."

-orangeblood

You're absolutely correct! Neither I or mathetes (if I may speak for mathetes) really believe that about price and book value. But to explain the PEG, this is the stance to take.

The PEG is based on this "pie in the sky" notion of a "fully and fairly valued situation," e.g., that price and earnings rise together in some lock-step fashion. I cannot imagine how the PEG could be conceived if earnings weren't considered to have a dollar-for-dollar affect on price. I further believe that the PEG was developed in some pre-Information-Age era when price and book value weren't too far out of sync.

In fact, over time, an enterprise that operates with assets of very little worth but has tremendous earnings shall, in time, also have tremendous book value - by virtue of the earnings! At some point, the earnings made will dominate its book value, making the marketable value of its actual working assets rather irrelevant. Microsoft is a case in point; the book value of that darn beast is nearly 90% cash!

My understanding of PEG is just that, that it was developed with the idea that price and book value would someday converge and be virtually the same, on the presumption that all earnings would be kept and no dividends paid. Otherwise, how could the "P/E = G" rule-of-thumb work even in an idealized world? The PEG wasn't meant to predict price, earnings, and growth per se; it was intended as a way to rank real live growing companies by comparing them to an ideal.

Of course, I could be missing the point. An explanation of the PEG (and Fool Ratio) from a different perspective would be most welcome!

BTW, Microsoft has a Fool of 2.7 (P/E=64, G=24). Despite its size and age, since it pays no dividends, the PEG may still be relevant - MSFT does get to keep everything it makes, after all. I wonder if it's really worth it to pay well over a hundred bucks to see what their company can do with the remaining seven and a half dollars just waiting to be put to better use. Growth of 24% looks great on paper, but that's about $3 a share next year, an abysmal much less than 3% return. My Foolish Four can give me that kind of return in dividends alone, and that'll be from the (neighborhood of) 20-25% of earnings from stocks that are around $50 a piece (more or less). No wonder Billy's going nuts trying to find the next big thing! So much is riding on speculation (or faith!) put upon his own talents and that of his company.
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