Normalizing Earnings for PE ratios

Catalyst Stocks Premium Stock Pick Service

How to Become a Stock-Picking Pro

Get Instant Access

The dependence of PE ratios on current earnings makes them particularly vulnerable to the year-to-year swings that often characterize reported earnings. In making comparisons, therefore, it may make much more sense to use normalized earnings. The process used to normalize earnings varies widely but the most common approach is a simple averaging of earnings across time. For a cyclical firm, for instance, you would average the earnings per share across a cycle. In doing so, you should adjust for inflation. If you do decide to normalize earnings for the firm you are valuing, consistency demands that you normalize it for the comparable firms in the sample as well.

The PEG Ratio

Portfolio managers and analysts sometimes compare PE ratios to the expected growth rate to identify undervalued and overvalued stocks. In the simplest form of this approach, firms with PE ratios less than their expected growth rate are viewed as undervalued. In its more general form, the ratio of PE ratio to growth is used as a measure of relative value, with a lower value believed to indicate that a firm is under valued. For many analysts, especially those tracking firms in high-growth sectors, these approaches offer the promise of a way of controlling for differences in growth across firms, while preserving the inherent simplicity of a multiple.

Definition of the PEG Ratio

The PEG ratio is defined to be the price earnings ratio divided by the expected growth rate in earnings per share:

PE ratio

Expected Growth Rate

For instance, a firm with a PE ratio of 20 and a growth rate of 10% is estimated to have a PEG ratio of 2. Consistency requires the growth rate used in this estimate be the growth rate in earnings per share, rather than operating income, because this is an equity multiple.

Given the many definitions of the PE ratio, which one should you use to estimate the PEG ratio? The answer depends upon the base on which the expected growth rate is computed. If the expected growth rate in earnings per share is based upon earnings in the most recent year (current earnings), the PE ratio that should be used is the current PE ratio. If it based upon trailing earnings, the PE ratio used should be the trailing PE ratio. The forward PE ratio should never be used in this computation, since it may result in a double counting of growth. To see why, assume that you have a firm with a current price of $30 and current earnings per share of $1.50. The firm is expected to double its earnings per share over the next year (forward earnings per share will be $3.00) and then have earnings growth of 5% a year for the following four years. An analyst estimating growth in earnings per share for this firm, with the current earnings per share as a base, will estimate a growth rate of 19.44%.

Expected earnings growth = [(1 + growth rateyr 1)(1+growth rateyrs 2-5)] 1/5-1 = ((1 + growth rateyr 1 ) + growth rateyrs 2-5 ))5 -1

If you used the forward PE ratio and this estimate of earnings growth to estimate the PEG ratio, you would get:

= Forward PE

ExPected growth next 5 years

Price

PEG ratio based on forward PE =_Forward EPS_

ExPect growth next 5 years

On a PEG ratio basis, this firm seems to be cheap. Note, however, that the growth in the first year has been counted twice - the forward earnings are high because of the doubling of earnings, leading to a low forward PE ratio, and the growth rate is high for the same reason. A consistent estimate of the PEG ratio would require using a current PE and the expected growth rate over the next 5 years.

Price

_ Current EPS

PEG ratio based on current PE Expected Growth rate«ext 5 years

Alternatively, you could compute the PEG ratio based upon forward earnings per share and the growth rate from years 2 through 5.

Price

Forward EPS

PEG ratio based upon forward PE

Expected growth $30

yrs 2-5

If this approach is used, the PEG ratio would have to be estimated uniformally for all of the other comparable firms as well, using the forward PE and the expected growth rate from years 2 through 5.

Building upon the theme of uniformity, the PEG ratio should be estimated using the same growth estimates for all firms in the sample. You should not, for instance, use 5-year growth rates for some firms and 1-year growth rates for others. One way of ensuring uniformity is to use the same source for earnings growth estimates for all the firms in the group. For instance, both I/B/E/S and Zacks provide consensus estimates from analysts of earnings per share growth over the next 5 years for most U.S. firms.

Cross Sectional Distribution of the PEG Ratio

Now that the PEG ratio has been defined, the cross sectional distribution of PEG ratios across all U.S. firms is examined in Figure 18.6.

Figure 18.6: PEG Ratios U.S. Stocks- July 2000

<0.25 0.25-0.5 0.5-0.75 0.75-1.00 1-1.25 1.25-1.5 1.5-1.75 1.75-2.00 2-2.5 2.5-3 3 - 4 4 - 5 >5

In estimating these PEG ratios, the analyst estimates of growth in earnings per share over the next 5 years is used in conjunction with the current PE. Any firm, therefore, that has negative earnings per share or lacks an analyst estimate of expected growth is dropped from the sample. This may be a source of bias, since larger and more liquid firms are more likely to be followed by analysts.

PEG ratios are most widely used in analyzing technology firms. Figure 18.7 contains the distribution of PEG ratios for technology stocks, using analyst estimates of growth again to arrive at the PEG ratios.

Figure 18.7: PEG Ratios for Technology Stocks United States - July 2000

0 J--—,--—,--—,---,---,---,---,---,---,--—,--—,--—,--—

<0.25 0.25-0.5 0.5-0.75 0.75-1.00 1-1.25 1.25-1.5 1.5-1.75 1.75-2.00 2-2.5 2.5-3 3 - 4 4 - 5 >5

Note that of the 448 firms for which PE ratios were estimated, only 335 have PEG ratios available; the 113 firms for which analyst estimates of growth were not available have been dropped from the sample.

Finally, Table 18.10 includes the summary statistics for PEG ratios for technology stocks and non-technology stocks5.

5 The PEG ratio is capped at 10.

Table 18.10: PEG Ratios: Technology versus Non-technology Stocks

Technology Stocks

Non-technology stocks

All Stocks

Mean

5.83

2.99

3.31

Standard Error

1.03

0.36

0.34

Median

2.03

1.13

1.18

Standard Deviation

18.05

17.68

17.74

Skewness

7.81

22.09

20.33

Range

198.62

569.73

569.73

Minimum

0.08

0.00

0.00

Maximum

198.70

569.73

569.73

Number of firms

309

2454

2763

The mean PEG ratio for technology stocks is much higher than the mean PEG ratio for non-technology stocks. In addition, the mean is much higher than the median for both groups.

The mean PEG ratio for technology stocks is much higher than the mean PEG ratio for non-technology stocks. In addition, the mean is much higher than the median for both groups.

pedata.xls: This dataset summarizes the PEG ratios by industry for firms in the United States.

Determinants of the PEG Ratio

The determinants of the PEG ratio can be extracted using the same approach used to estimate the determinants of the PE ratio. The value per share in a two-stage dividend discount model can be written as:

(1+ke,hg)".0i (EPSo)(PayoutRation)(l+g)"(l+gn)

Dividing both sides of the equation by the earnings per share (EPS0) first and the expected growth rate over the high growth period (g) next, you can estimate the PEG ratio.

Even a cursory glance at this equation suggests that analysts who believe that using the PEG ratio neutralizes the growth effect are mistaken. Instead of disappearing, the growth rate becomes even more deeply entangled in the multiple. In fact, as the growth rate increases, the effects on the PEG ratio can be both positive and negative and the net effect can vary depending upon the level of the growth rate.

Illustration 18.10: Estimating the PEG ratio for a firm

Assume that you have been asked to estimate the PEG ratio for a firm which has the same characteristics as the firm described in Illustration 18.1. Growth rate in first five years = 25% Payout ratio in first five years = 20%

Growth rate after five years = 8% Payout ratio after five years = 50%

Required rate of return = 6% + 1(5.5%)= 11.5% The PEG ratio can be estimated as follows:

Was this article helpful?

0 0
Stocks and Shares Retirement Rescue

Stocks and Shares Retirement Rescue

Get All The Support And Guidance You Need To Be A Success At Investing In Stocks And Shares. This Book Is One Of The Most Valuable Resources In The World When It Comes To

Get My Free Ebook


Post a comment