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No. of Recommendations: 4
Hi Fools
I would like to question the validity of the
Fool ratio. Please bear out with me in the long
argument.

Assume we have a business which is going to generate earnings
at a specified growth rate for a specified number of years. After
that its going to go bust :-).
Our goal is to compute the present value of those
earnings over the lifetime of the business at a given growth rate.

For sake of argument consider the risk free rate of return 10%.
This is satisfactory as it is close to the average long term return
of the market.

Now assume that we have 2 businesses which will continue to
grow earnings at rates of 20% and 50% for 10 years and then
stop earning anything at all.

The present values for each of the two businesses compute to be 15.25
and 58.38 respectively.
Now assume that the PEG of the
business growing at 20% rate is perfect ( ideal valuation).
In that case the business growing at 50% should have
been valued at 15.25 * 50 / 20 = 15.25 * 2.5 = 38.125.
However we have just calculated that the Present
value of the business is 58.38. Therefore our assumption
that the business growing at 20% is correctly priced is
wrong.
Let us now work the other way round and assume that the
business with 50% growth is perfectly priced. Now
according to the PEG formula the business at 20% growth
rate should be priced at 58.38/2.5=23.352. But again this
is obviously wrong.
This leaves us with only one alternative. The assumption
that PEG=1 means a fairly priced stock is wrong.
This is misinterpreted because of two reasons.
1) All earnings are not created equal. A company with
a earnings growth of 50% needs to be priced 58.38/15.25 = 3.8
times the company with 20% growth. This is because
compounding kicks in.
2) Secondly we do not specify the period of growth. For
example a company can grow at the rate of 20% for 100
years. If we were to know that for certain, then its
present value discounted by a 'safe' rate of 10% becomes
66096. How do we now justify a PEG of 66096/20=3304.8 ?

This is an extreme example but it serves to demonstrate
the point that when we compare two companies based
of PEGs we should make sure that the period over with
growth has been predicted is same.

In addition when comparing a stock with another based
on PEG we need to make sure that their growth rates are
in the same ballpark. Otherwise , as pointed out in
point (1) the company with a lower growth rate might
look cheaper, when actually it might be the other way
round.

cheers
neelnatu

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