Hi Fools I would like to question the validity of the Fool ratio. Please bear out with me in the longargument.Assume we have a business which is going to generate earnings at a specified growth rate for a specified number of years. Afterthat its going to go bust :-).Let us start with earnings of $1.00 at present.Our goal is to compute the present value of thoseearnings 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 returnof 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 thenstop 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 Presentvalue of the business is 58.38. Therefore our assumptionthat the business growing at 20% is correctly priced iswrong.Let us now work the other way round and assume that thebusiness with 50% growth is perfectly priced. Now according to the PEG formula the business at 20% growthrate should be priced at 58.38/2.5=23.352. But again this is obviously wrong.This leaves us with only one alternative. The assumptionthat 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 witha earnings growth of 50% needs to be priced 58.38/15.25 = 3.8times the company with 20% growth. This is because compounding kicks in. 2) Secondly we do not specify the period of growth. Forexample 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% becomes66096. How do we now justify a PEG of 66096/20=3304.8 ?This is an extreme example but it serves to demonstratethe point that when we compare two companies basedof PEGs we should make sure that the period over withgrowth has been predicted is same.In addition when comparing a stock with another basedon PEG we need to make sure that their growth rates arein the same ballpark. Otherwise , as pointed out in point (1) the company with a lower growth rate mightlook cheaper, when actually it might be the other wayround.cheers neelnatu
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