In his book "One Up On Wall Street", the chameleon investor, who is at ease with all management styles, praises a ratio that he uses in his investment strategy: the PEG. Price Earning to Growth adds a dimension to a company's valuation by relating its P/E to its earnings growth rate. A PEG of 1, indicates that the PER is equal to the growth rate of the company. The PEG is to Lynch what the PER is to Buffett. And if this ratio is lower than one, Peter Lynch considers that the company is undervalued.
Let us imagine that a company pays itself 30 times its profits (PER = 30), that means that the market capitalization of the company is 30 times higher than the net result. This may sound expensive. But if analysts expect earnings to grow by 30% per year, then the company's valuation is fair: the PEG is equal to one. However, this earnings growth rate must be constant over the medium term, so our example is only valid if the company is able to maintain its 30% growth rate over the next four years. Roughly speaking, this ratio makes it possible to justify a company's high P/E, if the growth rate of the bottom line is in line with it. However, the PEG quickly shows its limits. Which P/E should be chosen, the one for the current year? The estimate for the following year? The same question can be asked for the choice of the growth rate, at what horizon?
To calculate the PEG ratio, you take the P/E ratio of a company, find the expected growth rate for this stocks through analyst estimates. PEG = Share Price / Earnings per share / Earnings per Share growth rate
We are going to present you some companies with a PEG lower than one, chosen in the S&P 500. The PEG used for the article is calculated by dividing the 2022 P/E by an estimated long-term rate over the next 4 years.
DR Horton, PulteGroup
D.R. Horton and PulteGroup are two leading companies in the homebuilding industry. Buoyed by the U.S. economic recovery and a growing desire to move away from cities, homebuilders have their work cut out for them. The consensus expectation is that company profits will rise in the coming years. A trend that is also behind the recent rise in timber prices. Indeed, unlike France where only 11% of houses are made of wood, in the United States, it concerns 90% of houses. The great growth potential, coupled with a low P/E, explains the presence of this sector in the list. DR Horton and PulteGroup have PEG ratios of 0.37 and 0.40, respectively. Both companies have strong fundamentals, but the risk of lumber shortages is not negligible. D.R. Horton and PulteGroup have annualized earnings growth rates of 23% and 17% for the next four years
New Home Construction Trends (Projects Approved, Projects in Commencement and in Completion)
Facebook, Alphabet, eBay
It is hard to believe that these three companies are undervalued. However, if we follow Peter Lynch's reasoning, they are. Facebook 's PEG stands at 0.99, admittedly very close to 1. Alphabet Inc. and Ebay are also
slightly below this threshold with ratios of 0.96 and 0.84 respectively. Analysts expect their bottom line to move above the estimated 2022 PER. The three techs have high estimated annual growth rates: 13.5% for eBay, 23% for the parent company of Google and 22.5% for the social network created by Mark Zuckerberg.
Price trend of the three stocks since the beginning of the year, source: Marketscreener.com
Qualcomm, Skyworks, Micron
Many companies related to the semiconductor sector appear with a low price earning to growth ratio, such as Qualcomm, Skyworks Solutions and Micron Technology. They include a ratio between 0.40 and 0.70. It is still a shortage sector and full of uncertainties, in addition to being competitive. However, research firms seem confident given the evolution of earnings revisions, which are clearly on the rise. Over four years, the long-term annualized growth rate is over 25% for Qualcomm, nearly 21% for Skyworks and 18% for Micron Technology.
MSCI Semiconductors Index
Multiples such as P/E or PEG are methods that generally allow a company to be valued relatively, i.e. in comparison with competitors or an entire sector. For more relevance, we never use these ratios "alone".