{"id":3577,"date":"2011-02-19T04:34:20","date_gmt":"2011-02-19T11:34:20","guid":{"rendered":"http:\/\/www.jasonapollovoss.local\/?p=3577"},"modified":"2018-09-21T02:08:05","modified_gmt":"2018-09-21T06:08:05","slug":"is-apple-stock-cheap-the-fallacy-of-peg-ratios","status":"publish","type":"post","link":"https:\/\/jasonapollovoss.com\/web\/2011\/02\/19\/is-apple-stock-cheap-the-fallacy-of-peg-ratios\/","title":{"rendered":"Is Apple Stock Cheap? – The Fallacy of PEG Ratios"},"content":{"rendered":"

WHAT IS THE PEG RATIO?<\/strong><\/span><\/p>\n

In case you have never come across this quaint, and potentially dangerous, little valuation shortcut, let me provide a brief overview.\u00a0 The PEG ratio compares the price to earnings (P\/E) ratio of a business to its expected future growth rate (G); this period is typically five years.<\/span><\/p>\n

P\/E \u00f7 G = PEG ratio.<\/span><\/p>\n

Sometimes you will see a P\/E ratio in the calculation that utilizes next year\u2019s expected earnings, rather than the more typical version that uses the company\u2019s current P\/E.<\/span><\/p>\n

The supposed wisdom behind the PEG ratio says that a P\/E ratio, even a forward-looking one, only accounts for the grow<\/span><\/p>\n

th in an earnings stream one year out.\u00a0 By incorporating the company\u2019s expected growth rate for a longer period of time, like five years, you supposedly get greater insight into whether or not it makes sense to buy stock in a company.\u00a0 Just like a P\/E ratio, the lower the PEG ratio is, supposedly<\/em> the less expensive is the stock.<\/span><\/p>\n

SHOULD I TRUST THE PEG RATIO?<\/strong><\/span><\/p>\n

Importantly, does the PEG ratio have any basis in reality and can you trust it?\u00a0 To both questions the answer is: sort of, but not really.\u00a0 In evaluating these answers, believe it or not, no subjectivity is necessary.\u00a0 How can that be?<\/span><\/p>\n

PEG ratios are actually based on mathematics.\u00a0 Shockingly, the PEG ratio is only accurate under a very specific set of circumstances that are rarely ever met in the investment market place.<\/span><\/p>\n

CASE STUDY: Apple<\/a> (AAPL<\/a>)<\/strong><\/span><\/p>\n

Because almost all of us know and love Apple as a business \u2013 if not necessarily as a stock – I am going to use it as an example to illustrate my points.<\/span><\/p>\n

As of the close February 17, 2011 shares in technology juggernaut Apple are selling for $358.30.\u00a0 Compared to trailing earnings per share<\/em> of $17.92, those two figures give us a P\/E of:<\/span><\/p>\n

$358.30 \u00f7 $17.92 = 19.99x<\/span><\/p>\n

Yahoo! Finance reports that Apple\u2019s five year expected growth rate (G) in earnings is 26.3%<\/a>.\u00a0 So, in turn, that gives us an Apple PEG ratio of:<\/span><\/p>\n

19.99x \u00f7 26.3% = 0.76<\/span><\/p>\n

[Note: if you actually crank out this math you know that you don\u2019t really get 0.76.\u00a0 That\u2019s because the growth rate is not treated as 0.263 (or 26.3%), but as 26.3 for the PEG ratio calculation.]<\/span><\/p>\n

Okay, so now that we have our PEG ratio, 0.76, what does it mean?\u00a0 Traditionally, if your PEG ratio is greater than 1.0 it means that the business you are looking at is overvalued and that you shouldn\u2019t buy that company\u2019s stock unless you feel that the growth rate, G, used to calculate the PEG ratio, is too low.<\/span><\/p>\n

Conversely, if the PEG ratio is less than 1.0 it means that a business is fairly valued, and in fact, trading at a discount.\u00a0 Such a purchase is done with a classic Graham and Dodd, value investing, margin of safety it is said.\u00a0 A PEG ratio of approximately 1.0 supposedly is an indication of fair value.<\/span><\/p>\n

So if I were to invest in Apple using the traditional understanding of the PEG ratio I would normally conclude that shares in the business are cheap; actually, not just cheap, but super cheap.\u00a0 Shares in AAPL<\/a> are trading at a:<\/span><\/p>\n

( 0.76 PEG \u00f7 1.0 PEG ) \u2013 1 = 24.0% discount to fair value<\/span><\/p>\n

WOW!\u00a0 Apple looks like a steal.\u00a0 But here is where we bump up against my point: the fallacy of the PEG ratio as a valuation measure.\u00a0 Someone trusting this rule of thumb valuation measure has the potential of really being stung<\/strong>.\u00a0 Here\u2019s why.<\/span><\/p>\n

An investor buying Apple at the 0.76x PEG ratio would be sadly disappointed to learn that he would only end up with a 8.9% compound annual growth rate at the end of five years.\u00a0 This assumes that the 19.99x multiple paid<\/em> holds flat (i.e. the return of capital at the end is the same as put in), but that Apple does, in fact, deliver average annual earnings growth of 26.3%.<\/span><\/p>\n

The above result is mathematically derived; the only subjectivity is in my assumptions \u2013 that is, does Apple deliver those earnings, and does its P\/E multiple stay flat?\u00a0 And I am being generous with my assumptions, too.\u00a0 I am assuming that you, as an investor, would be happy with a 0.0% rate of return.\u00a0 In other words, I\u2019m not factoring in your expectations for return in this calculation.\u00a0 Normally investors should<\/em> factor in their return expectations \u2013 their required return \u2013 when evaluating investments.<\/span><\/p>\n

What happens if I factor in a five year expected rate of return on my part of just 10%?\u00a0 Well then the return for Apple drops to 6.7%.\u00a0 Okay, you might say, this is surprising, but Apple will take its earnings and reinvest them in the business and earn high rates of return on that re-invested capital.<\/span><\/p>\n

Let\u2019s assume then that Apple does pump all of its retained earnings back into innovative, juicy products like the iPod, iPhone and iPad and that it continues to earn 26.3% on those new products.\u00a0 Even in this scenario, Apple just meets the breakeven required rate of return, delivering a 10% compound annual return.<\/span><\/p>\n

Correct me if I am wrong, but I think that when most people invest in a business like Apple they are expecting their return to be the same as the company earnings growth \u2013 in Apple\u2019s case, that\u2019s our familiar 26.3%.\u00a0 But instead, we need aggressive assumptions just to get to a 10.0% rate of return even though Apple\u2019s PEG ratio is 0.76.\u00a0 And this demonstrates the fallacy of the PEG ratio.<\/span><\/p>\n

So how is it that the PEG ratio breaks down?<\/span><\/p>\n

Here is a list of the principle PEG ratio problems to be aware of, as revealed by mathematics:<\/span><\/p>\n

1.\u00a0 The PEG ratio doesn\u2019t account for the time value of money.\u00a0 That is, when you invest $358.30 in Apple in exchange for just $17.92 of earnings, those earnings have to grow rapidly \u2013 in fact, more rapidly than the expected earnings growth rate of 26.3% \u2013 for you to earn your required return.<\/span><\/p>\n

2.\u00a0 The PEG ratio makes no assumption for how the business or you reinvest earnings.\u00a0 And even when you factor this in to your calculations, you still need much more massive earnings growth than the PEG ratio would imply you need, again due to the time value of money.<\/span><\/p>\n

3.\u00a0 The PEG ratio doesn\u2019t factor in your investment time horizon unless you were careful in using an earnings growth rate commensurate to your preferred time horizon.\u00a0 In the above examples with Apple under the microscope I assumed five years.\u00a0 But if your investment time horizon is just 3 years, then in the aggressive case Apple only returns 7.7%.\u00a0 By contrast, a time horizon of 10 years generates a compound annual growth rate of 15.4%.\u00a0 However, most businesses cannot grow their earnings at such high rates of return (26.3%) for a decade, especially when they are beginning at an earnings base in the billions, as is Apple.<\/span><\/p>\n

4.\u00a0 Very importantly, the PEG ratio treats all 0.76x ratios as being the same<\/strong>, when in fact they are very different.\u00a0 For example, Apple\u2019s PEG ratio of 0.76 is a combination of a P\/E of 19.99x and a growth rate of 26.3%.\u00a0 Recall that in the baseline case this resulted in a 8.9% annual return.\u00a0 But what if instead that 0.76 PEG were achieved by:<\/span><\/p>\n

9.995x P\/E (exactly half of Apple\u2019s) \u00f7 13.15% Growth rate (again, exactly half) = 0.76 PEG ratio<\/span><\/p>\n

The results are actually dramatically different.\u00a0 In this case the average annual five year return is 11.7%, not the 8.9% of Apple\u2019s 0.76x PEG ratio!<\/span><\/p>\n

Likewise, a PEG ratio where Apple\u2019s P\/E and Growth rates are doubled, 39.98x and 52.6%, respectively, also provides a dramatically different result.\u00a0 Here the compound annual return is 8.8%.\u00a0 While comparable to Apple\u2019s actual expected compound annual return of 8.9%, remember that an investor buying at a PEG of 0.76x where the five year growth rate in earnings is expected to be 52.6% will be sorely disappointed.<\/span><\/p>\n

The culprit again is the time value of money.\u00a0 A P\/E of 39.98x means that you are trading $39.98 for $1 of earnings.\u00a0 This is an exchange that you wouldn\u2019t likely make at a Las Vegas casino.\u00a0 So that $1 of earnings has to grow very, very fast to make up for the disparity in what you paid at the outset to what you receive over the intervening years.<\/span><\/p>\n

WHEN DOES THE PEG RATIO HOLD UP?<\/strong><\/span><\/p>\n

So in what very special case do you actually earn the same rate of return that the company does?\u00a0 That is, if I buy Apple shares wanting my rate of return to equal Apple\u2019s 26.3% earnings growth rate, how do I do that?<\/span><\/p>\n

Unfortunately, the traditional PEG ratio heuristic of \u201ccompanies are a value when the PEG ratio is less than 1.0x\u201d focuses your attention incorrectly \u2013 it is close, but no cigar.<\/span><\/p>\n

The two things you want to focus on are:<\/span><\/p>\n

1.\u00a0 All three rates of return involved in the investment are identical, and without any deviation.\u00a0 These three returns are:<\/span><\/p>\n