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I was drawn here by an e-mail I received from a lurker who had read augieboo's recent hard work in calculating PEGs and wanted to know how valuable PEG really was as a valuation tool. Let me say up front that my intention isn't to denigrate the value of those posts or future posts (augieboo never made any claims overstating the value of PEG, as far as I could see), but I thought I'd point out some of the shortcomings of PEG, because it can be a tempting but sometimes misleading one stop shop in valuation due to its seeming simplicitly. If you are already fully versed in this stuff, you might want to hit 'next'.

PEG, like PE, is a heuristic. A rule of thumb meant to approximate the intrinsic value of a company relative to the price the market is charging to own that company. Because intrinsic value is defined as the risk adjusted present value of all the cash you expect a company to throw off to shareholders in its lifetime, and because those expected cash flows can involve time consuming and complicated calculations, people develop short cuts as a proxy to those cash flows. Proxies are, by definition, not as robust as the real thing; and so the question here is how far PEG is from the real thing (DCF). The short answer is, pretty far. Here are some ways PEG invites serious variation from actual value.

1) Accounting Earnings are Not Cash Flow. This may actually be the least of PEG's problems, but it's an issue nonetheless. Earnings per share are a fiction meant to fit the economics of a business into a given period. Companies with large working capital (inventory and receivables) requirements, for example, often have less actual cash flow than that represented by earnings. There are many potential disparities between earnings and cash flow (depreciation may be a poor indicator, purchase accounting goodwill may be a misleading cost, stock option issuance and subsequent share repurchases may be ignored, to name a few), which are good to keep in mind. Most important in this category is that, by ignoring reinvestment needs (growth cap ex plus working capital), there is a danger of missing a major component of cash flows in your valuation proxy.

2) PEG is a Linear Measure of an Exponential Phenomenon. This failing is extremely important. PEG is often applied against a default benchmark (i.e. a PEG < 1 or 1.5 is considered "good"). One problem with this practice is that PEG ratios are not comparable across growth rates, because growth is exponential (compounds) and PEG is a linear, static measure. Here's an example of what I mean.

Say NTAP, with TTM earnings of $100 million, was expected to grow earnings at 50% for 10 years and then at 5% into infinity. EMC, also with $100 million in TTM earnings, is hypothetically expected to grow earnings at 20% for 10 years and then at 5% into infinity. Assuming a 15% discount rate (and that all earnings are reinvested until year ten and then all earnings are free cash), NTAP would be worth $14.97 billion, while EMC would be worth $1.61 billion. So the appropriate PEG for NTAP would be 2.99 [(14967/100)/50], while the appropriate PEG for EMC would be 0.80 [(1607/100)/20]. So the use of PEG can invoke serious mistakes simply because companies growing at different rates cannot be compared linearly. Just as a P/E of 100 might be justified under certain expected conditions, a PEG over two may also be perfectly appropriate, and a PEG under 1 may be too high. (Note by the way, that a rule saying that "higher growth rates deserve higher PEGs" is also inappropriate. In fact, the lowest growth rates often require the highest PEGs to be fairly valued.)

3) PEG Does Not Account For the Length of the Growth Period. PEG, particularly as applied to the sorts of companies discussed on this board, does not give any indiication of one of the most important determinates of actual value: the length of the growth period(s). A company might have current growth of 65%, but expected 5 year growth of 15%. Or a business might have expected 5 year growth (the most common input for "G") of 20%, but could be expected to hit maturity (say, 5% infinite growth) at year 6 or in year 25. The difference is extraordinary, but PEG has nothing to say about it. I'll use an example from augieboo's chart.

According to the chart, QCOM has an expected one year growth rate of 30%, while Cree has an expected growth rate of 29%. QCOM, however, has a PEG over 2.01 versus Cree's seemingly more attractive PEG of 1.37. But this captures so little of the picture it might be safe to call it irrelevant. Say QCOM's growth (assuming it's all free cash flow - no reinvestment) at 30% persisted for 10 years, and then subsided to 5% into infinity. Meanwhile, CREE is expected to grow at 29% for three years, and then 15% for seven years, and then 5% into infinity. Against using a 15% discount rate, CREE's appropriate PEG would be 0.98. QCOM's meanwhile, would be 1.88. Same growth rate, same discount rate, but vastly different PEG values.

4) PEG Does Not Account For Risk. This should be obvious. Even if one company's PEG was an accurate or comparable read to another's, PEG does not take into account varying risk between companies, although I'd guess that most investors would require greater returns from RBAK than from INTC.

5) PEG Fails to Account For the Impact of Interest Rates. This is similar to (4), but it's important because often people use absolute benchmarks like PEG < 1 = good to assess value. But treasury (or risk free rates) rates have a huge impact on the appropriate PEG. The lower interest rates are, the higher PEGs should be (just as lower interest rates justify higher equity prices). A PEG of 1.2 in 1981 may well have indicated a company was overvalued, while a copmany with identical growth rates and attendant risk may be very undervalued at that same PEG relative to 2001's lower interest rates.

This turned out to be pretty long. At the least, the conclusion ought to be to look well beyond PEG in determining value. To me, PEG is so inherently flawed that it provides little to no value as a proxy for valuation, but opinions may differ.


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