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Traditional Valuation Could Lead to Missed Opportunity

July 01, 2013



A popular indicator for many investors is the PEG ratio. Generally, the PEG ratio is calculated by dividing the P/E multiple by the company's projected earnings per share growth rate over the next year. For example, if a stock is trading at 20 times earnings and has a growth rate of 40%, the PEG ratio would be 0.5 (20 ÷ 40). The company is trading at half its growth rate.

The theory is that if the resulting value is less than 1, the stock may be undervalued; if the PEG ratio is over 1, the stock may be overvalued. The farther the value is from 1, the stronger the signal.

In general, if a company’s earnings growth rate matches or exceeds its P/E multiple, investors using the PEG ratio for valuation may consider the stock fairly valued, or even undervalued. If the P/E multiple significantly exceeds its growth rate, however, the stock would be considered risky and overvalued according to this school of thought. Many analysts intent on buying “growth at a reasonable price” (GARP) use PEG ratios in various forms.

The point at which a stock is deemed undervalued or overvalued can vary, depending on the analyst. Some investors look to pare their holdings in a stock as soon as its price multiple exceeds its growth rate by any margin. I don’t look at this ratio as a very valuable tool in my investing arsenal because it can exclude some of the most dynamic and profitable companies from a candidate buy list.

The PEG ratio is limiting on the two sides of the equation; when a stock has an exceptionally high or low P/E. Should a stock with a growth rate of 2% trade at two times earnings? On the other hand, valuing a high technology stock like Yahoo, which traded at 938 times earnings in 1997, was nearly impossible utilizing traditional valuation measures.

As I recall, in the 1990s many analysts changed their valuation tactics and started using revenue models instead of earnings to value the internet and dot.com stocks. From that perspective, Yahoo turned out to be definite bargain at that price. The stock advanced 7800% and the PE ratio ballooned to 2000 times earnings.

Some analysts utilize more complex forms of the PEG ratio. My friend John Bollinger introduced me to one such analyst, Vitaliy Katsenelson, who is a Certified Financial Analyst out of Denver, Colorado, and author of the book Active Value Investing (Wiley Finance, 2007). Allow me to encapsulate his approach based on my discussion with him.

Katsenelson starts with a no-growth P/E of 8 and then adds P/E points for growth. However, as growth rates get higher, incremental P/E points get smaller because, in his opinion, higher growth usually carries higher risk. He also factors in dividends, adding additional P/E points—something that the traditional PEG model ignores.

This approach gives Katsenelson a base P/E number for an average company. Once he determines that number, he adjusts the P/E further based on the following risk metrics: business risk, financial risk, and, finally, earnings visibility—claiming that the further out you can forecast a company’s growth rate, the more valuable the company.

Katsenelson’s method is like starting out with a base price for a stripped-down model of an automobile and then adding value if the car has extras like air conditioning, power steering, and alloy wheels, but taking some value away if the car has too big of an engine for fear it will go too fast and crash.

Katsenelson readily admitted to me that the drawback of this approach is not being able to apply it to companies with huge growth rates, and therefore, missing out on some market leaders such as Yahoo.

Wall Street has little idea what P/E ratio to put on companies growing at huge, unsustainable growth rates. It’s extremely difficult, if not impossible to figure out and predict with any degree of accuracy how long a growth phase will last and what level of deceleration in growth will take place over a given timeframe when dealing with a dynamic new industry.

True market leaders tend to move to extreme valuations and leave many analysts in awe as their stock prices continue to climb into the stratosphere in spite of what appears to be a ridiculous P/E.

For many, missing out on these great companies is due to a misunderstanding of how Wall Street works at this particular point in a stock’s lifecycle, and, therefore, concentrating on the wrong price drivers.

If you want big performance in stocks, don’t allow a high PE or PEG ratio to discourage you from owning a dynamic new market leader. Leading stocks almost always look “expensive.” By the time they look "cheap" their big move has usually passed.
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Mark Minervini



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