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How to Pick Stocks by Using the P/E and PEG Ratios

In investing as in most areas of life, a little knowledge can be a dangerous thing.

Most investors have a rough understanding that low Price to Earnings ("P/E") stocks are or might be bargains and that high P/E stocks are expensive. Most investors also understand that high growth stocks usually have a higher P/E.

Unfortunately, most investors have very little understanding of exactly why this is and exactly how the math works. Therefore, most investors are not in a position to judge when the P/E of a stock is too high and when it truly is a bargain.

Below are concise and practical rules for use of the P/E ratio.

For the more ambitious reader more detailed analysis of the mathematics of the P/E ratio is available. See the following:

Understanding the P/E ratio

Is that P/E of 20 a bargain or not?

 

www.investorsfriend.com's Practical Guide to P/E and PEG ratios

(Keep this Guide handy when placing Buy and Sell orders on the basis of P/E)

The P/E ratio values a stock as a multiple of its initial earnings. Fundamentally this is actually not an ideal way to value a stock because the future earnings of a stock could vary radically and in unexpected ways from its initial earnings. Nevertheless, the P/E ratio can provide some guidance in certain cases.

The P/E ratio can only be used to value stocks for which a representative initial earnings per share is available.

- The earnings must be adjusted for unusual gains and loses. Never apply the P/E ratio to judge if a stock is a bargain without checking if the earnings are abnormally high or low due to some unusual or one-time items. The use of a P/E ratio to judge a stock implicitly assumes that the earnings provide a sustainable basis from which to forecast future earnings.

- P/E is of little or no use for very cyclic or commodity linked stocks since we can not judge if the initial earnings are in any way indicative of future earnings

- P/E is of little or no use for start-up companies since the earnings will not have reached a stable representative level

- P/E ratio is of most use in cases where a company has a history of stable earnings or stable growth which is expected to continue in the future.

For stable, predictable companies, the maximum justifiable P/E ratio is heavily dependent on the growth rate, the dividend pay-out ratio, and the appropriate required rate of return (which in turn is affected by the risk free long term interest rate, expected inflation and the non-diversifiable risk of the company).

The following table indicates the highest justifiable P/E ratio for various levels of these variables. A stock trading at a P/E level substantially below the maximum level that can be justified by its perceived growth, dividend and risk may be a bargain. However, investors should also show due respect to the "wisdom" of the market, there may be unknown reasons why a stock is trading at what appears to be a bargain level.

From this table, it is apparent that it is dangerous to generalize about the P/E ratio. For example statements such as a P/E of over 20 is "too high" or a P/E of under 10 is always a bargain are quite false and quite dangerous. A fair level of P/E for a stock can only be judged after considering the likely growth, the dividend pay-out ratio and the required rate of return. These variables MUST be input into a calculation formula or looked up in a table such as this. It is interesting that many analysts rely on the use of P/E ratios and yet tables such as this are not widely available.

It does appear that some very rough generalizations can be made about the PEG, but only if we make allowances for the dividend pay-out ratio and the required rate of return. The PEG ratio is the P/E divided by the initial growth rate. Assuming an 8% required rate of return, a rule of thumb for P/E is that for companies which retain all earnings (it is assumed that a dividend of 50% will apply beginning after 10 years), the PEG ratio should not exceed 1.5. For companies that dividend out 50% of earnings, the PEG ratio should not exceed 2.0 If the required return is changed to 10%, it appears maximum PEG should be no higher than about 0.9 if there is no initial dividend and no higher than about 1.4 for an initial dividend pay-out ratio of 50%.

Growth - Higher initial growth rates can lead to dramatically higher justifiable levels for the P/E ratio. The initial growth rate is the forecast average annual growth rate for the first ten years. After ten years it is assumed that the growth rate will stabilize at a sustainable level that reflects to normal growth of a healthy company. For a company that pays out 50% of earnings as dividend, a sustainable growth rate is 4% which corresponds to a return on equity of 8%. Note that this refers to growth on a per share basis. A company which grows by 10% but which has issued 10% more shares has a zero growth per share. Note that it is very aggressive to forecast an annual compound  growth rate of 15% or higher. It can be very dangerous to pay for this type of growth since there is a large down-side risk if the growth does not appear (i.e. Nortel)

Dividend - Scenarios are provided above for two dividend assumptions. A zero dividend policy is typical of early stage and higher growth companies. A 50% dividend pay-out ratio is more typical of a mature company. In both cases it is assumed that after ten years the dividend pay-out ratio is fixed at 50%. A zero dividend policy assumption for the very long term leads to mathematical difficulties. If all earnings are retained for many decades then the value of the company converges toward zero if the percentage earnings growth is lower than the required return and converges toward infinity if the percentage earnings growth is higher than the required return ( a perpetual money machine!). The math suggests that it is more logical to assume that a dividend will occur at some point and I have assumed a pay-out of 50% of earnings starting after ten years. 

Return - Two scenarios for the required return are provided, 8%and 10%. This may seem low to those that would "like" 15% but the fact is that in today's low interest rate environment an average stock market return of 8% to 10% is a fair level. In some cases we might like to discount at a higher rate, but alternatively, one can lower the assumed growth rate to deal with risk.

Subsequent growth - The above table is calculated by assuming that the subsequent growth occurs for an additional 40 years. At the end of the total 50 year period it is assumed that all retained earnings are flowed back to the investor. My calculations indicate that the the value of the earnings beyond 50 years would not change the P/E in a material manner.

The above table provides a range to show what the P/E ratio should be over a broad range of growth and for the two dividend and required return assumptions. This should help investors to judge whether a given P/E level is a bargain or not.

August 30, 2001 

Disclaimer: The above figures are believed to be mathematically accurate based on the assumptions provided. However, accuracy cannot be absolutely guaranteed.

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