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Author: ribofunk Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 2003  
Subject: Reply: Zero-Growth P/E's Date: 9/25/1997 3:40 PM
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gharnett wrote on Sept 13:

<One problem with the PEG is that a stock with an EPS growth rate of
<0 by this standard evaluates to zero. Yet a stock that yields forever <a constant return of is not worthless. Even if there is inflation, it <has some value, though no doubt we'd reduce its value proportionate <to the inflation rate.


I've wondered about the same question--I own some stocks of companies which are profitable, but whose growth is expected to be negligible, such as CNXS and FATS. That income stream is definitely worth something.

Here's what I've come up with so far:

(1) There a probably 'relevant range' for the P/E-to-EPS-growth relationship. Outside that range, the relationship doesn't hold. Zero growth definitely justifies a P/E of more than zero. On the other hand, growth of 200% (which some small companies have) rarely justifies a P/E of 200, simply because that level of growth is unlikley to be sustained for very long.

I would guess the relevant range to be, conservatively, say, 20-50%? Maybe 15-75%? Outside of that range, perhaps it breaks down. Anyone have a thought on this?


(2) Since PEGs are based on the P/E=EPS growth relationship, perhaps PEGs are not trustworthy for very high- and very low-growth companies.

For example, Llama's comment to me of a few weeks ago on FCPY seemed quite insightful, namely that the market is unlikely to reward a 100% growth rate with a P/E of 100. On the low side, the PEGs I've run with low-growth companies seem to be much more anemic than the stocks deserve.


(3) As far as zero-growth companies: a stock with zero earnings growth is kind of like a bond, which returns a fixed amount every year. Let's say bonds return 6.4%. A stock which 'acts like' a bond would have a Return on Equity (or EPS/Stock Price) of 6.4% and no projected earnings growth.

The Price-Earnings ratio of this stock would be 15.6 (100/6.4). In other words, a P/E ratio of 15 would mean this stock is valued like a bond. (A company with 50% lower profit margins should command a 50% lower price, but the P/E ratio would stay at 15.)

Theoretically, a stock has greater risk, so perhaps the breakeven P/E would be lower than 15. On the other hand, a bond carries the risk that interest rates will change unfavorably.

For anyone thinking of applying this, DO NOT TRUST MY LOGIC! In fact, please, somebody tell me if I'm crazy. I'm just trying to think through the logic of valuing zero-growth companies. Instinctively,
15 seems like too high for a breakeven P/E--most mature, zero-growth companies seem to have P/Es of less than 10. Does this mean they're undervalued?


I eagerly await any and all input.


Jack Neefus
College Park, MD



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