Valuation V. Derivation of PEG Analysis.

What about the PEG analysis everyone uses? Does that have any fundamental basis?

Whence came PEG? ;-)

PEG is the PE to growth rate ratio, and is commonly used to value stocks with high growth. [btw, the term "PE" = P/E ratio in common usage] The actual PEG ratio is PE / 100g, since the growth rate "g" is used as percentage, not a discount decimal number. If PEG is greater than one (viz. the PE is more than the growth rate expressed as a percentage), then the stock is deemed overvalued. If PEG is less than one, the stock is deemed undervalued. And if PEG = 1, then the stock is fair valued.

[NB: from prior posts on "Valuation", you can see this method fails miserably in valuing stocks with slow, zero and declining growth stocks. PEG has pesky divergences in the two latter cases and produces a silly answer in the first case.]

We can analyze PEG as a valuation method by inserting P/E = 100g into our infinite growth equation P/E = 1/(r-g) and solving for the discount rate, "r".

A little algebra gives r = g + (1/100g). So if g is reasonably large, the approximation r = g is very close. (Example: for 50% growth, g = .5. So r = .5 + 1/(100 x .5) = .5 + (1/50) = = .5 + .02 = .52)

So the PEG method implicitly values a stock assuming the discount rate is equal to the growth rate.

I suppose a high growth, risky business needs a high discount rate, and using r = g is arguably close enough. Would a high growth business only invest hard $ unless its equity rate of return was at least its growth rate? I suspect they often invest expecting a much lower equity rate of return. The business might just be expanding rapidly into new markets or sectors or locations, with much extra risk at all.

So PEG might be a useful tool, but remember what its use implies & evaluate the ratio with that insight. Think about the true business risk of the company. A high growth stock, say with 50% growth, might be a steal even if the PE is 60x if the business risk is not too high.

PS: You can easily see the PEG method fails miserably for slow, stable growth. The equation, r = g + (1/100g) derived above gives silly results in that case. If a company grows at 5% very steadily - safely - the equation implies the risk discount rate r = .25, or 25%. Of course the business risk of such a company is much lower. So the PEG method simply fails for slow or even moderate growth.