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Which Is the Better Valuation Metric? The P/E Ratio or the PEG Ratio: Part 1

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Introduction

Recently, I have been engaged in rather intense discussions regarding the validity of P/E ratios versus PEG ratios as proper or appropriate valuation metrics.  I generally find these types of debates befuddling for a couple of reasons.  One, they are often a result of a failure to communicate.  Either party or sometimes both parties assume that their adversary holds or supports a specific position which may or may not be a fact.

From my perspective, this was precisely the case regarding the discussion cited in my opening sentence.  Assumptions were made regarding my positions on P/E ratios and the PEG ratio that were not positions that I actually hold.  Consequently, it is hard to argue or debate an issue when you are essentially being required to defend a position that you do not hold.

The second reason I find these types of discussions puzzling is because they are often over generalized.  Financial metrics such as the P/E ratio or the PEG ratio, like most financial metrics, have their place and their value in financial analysis.  Consider that a P/E ratio is a statistical metric referencing a single point in time.

However, in the real world, the P/E ratio is a dynamic measurement that is constantly changing over time.  Moreover, just as it is with all financial metrics, I don’t believe any metric is supremely valuable in a vacuum.  In my experience and opinion, all financial metrics will only bring investors value and insight when utilized relative to other metrics.

Therefore, with this series of articles I will share my perspectives, opinions and insights into how both the P/E ratio and the PEG ratio can be appropriately utilized by investors towards making better informed investment decisions on common stocks.  Additionally, I will discuss how both of these commonly used financial metrics are for all intents and purposes joined at the hip.  In other words, they are more interrelated metrics than they are separate or distinct valuation tools.

The P/E Ratio: Definitions and Insights

The P/E ratio is one of the most commonly utilized tools for the serious common stock investor. It is, however, one of the most misunderstood and misused tools. Learning how to use it properly and understanding its significance can significantly increase returns and lower risk.

The P/E Ratio – Definitions:

The P/E Ratio can be defined in several ways, with each definition adding insight to its significance. The simplest definition is simply the price of the common stock divided by its earnings per share. This is a basic mathematical definition expressed as follows:PRICE/Earnings = P/E Ratio.

A second commonly used definition is: The P/E Ratio is the price you pay to buy $1.00 worth of a company’s earnings or profits. For example, if a company’s stock has a P/E Ratio of 10, then you must pay $10 for every dollar’s worth of that company’s earnings or profits you buy. If its P/E Ratio is 20, then you pay $20 for every dollar’s worth of that company’s earnings or profits, and so on.

It is important to note, however, that a higher P/E Ratio does not necessarily mean that the company has a higher valuation or that it is more expensive than a company with a lower P/E Ratio. This fact is not understood by many investors and is the key reason that the P/E Ratio has little value by itself or if used in a vacuum. It is theoretically possible, depending on each company’s future prospects, that a company with a P/E Ratio of 10, for example, can be significantly more expensive than a company with a P/E Ratio of 40. I will elaborate on this important point later.

A third definition would be: How many years in advance you are paying for this year’s earnings. For example, if a company has a P/E Ratio of 20, then you are paying 20 times this year’s earnings. If the P/E Ratio is 10, you are paying 10 times this year’s earnings, and so on. This definition illustrates a simple premise of what an operating business is worth.

What is a Fair Value P/E Ratio?

As an example to illustrate this important point, I offer the following analogy based on the earnings of a private business. If you had a private business that was netting you $100,000 net, net, net after all expenses and taxes, it is unlikely that you would sell it to me for $100,000, or a P/E Ratio of 1.

A business that generates an annual revenue stream for its owner has a value greater than one year’s profits.  This is true even if the company is not growing or not growing very fast.  For example, let’s assume that the above private company does not grow, but that it does pay a consistent $100,000 per year of net income.  If the owner sold it for one times earnings ($100,000) he or she would essentially have no money coming in after the end of the first year.

So this raises the question, what value should an owner place on a business they are desirous of selling?  The optimum value would be to sell the business for a price where the net proceeds could be invested in order to generate a comparable income stream.

Note: since this is being offered as a theoretical mathematical exercise, I will assume no taxes or other costs associated with a sale.  Therefore, for illustration purposes, let’s assume the owner was confident that he or she could earn a reasonable 6.67% return on their proceeds from the sale of the business.  If this were true, the owner would need approximately $1,500,000 net after taxes earning 6.67% ($1,500,000 x 6.67% equals $100,050) in order to replace the $100,000 per year they were receiving from their business.  In other words, this valuation represents a P/E ratio of 15.

From the purchaser’s perspective, if they paid $1,500,000 for the example business (the P/E ratio of 15), he or she in turn would be receiving a current earnings yield of 6.67%.  Earnings yield (E/P) is the inverse of the P/E ratio.  Since the average rate of return from common stocks has ranged between 6% – 8% historically, a 6.67% expected current return might be considered reasonable by both the seller and buyer.  If this were true, then this transaction theoretically benefits both buyer and seller and could be consummated.

This exercise establishes the P/E ratio of 15 as a baseline or rational valuation level from both a buyer’s and a seller’s perspective.  This does not suggest that it is a perfect calculation of fair value, intrinsic value or true worth.  Instead, a P/E ratio of 15 represents a sound valuation level that a business generating an income stream is worth, even if the business isn’t growing.  However, this valuation level is only relevant if the business is generating a positive level of earnings.  Therefore, I suggest that the reader might consider a P/E ratio of 15 as a benchmark for a sound valuation reference for average growing companies.

Moreover, a P/E ratio of 15 as a sound valuation reference is useful for most companies when their earnings growth is 15% or less.  There are many investors that find this last statement either illogical or hard to accept.  However, in my experience analyzing thousands of companies over many decades, the 15 P/E ratio as a valuation reference is fully supported in real-world circumstances.  In my opinion, this speaks loudly to my earlier point that the P/E ratio cannot be utilized in a vacuum.  Furthermore, a sound valuation does not in itself guarantee a high level of future returns.

In order to ascertain future return potential, I believe the P/E ratio needs to be evaluated in relation to the earnings growth potential of the company in question.  A 15 P/E ratio represents soundness as illustrated in my private company example above.  However, it is the P/E ratio in relation to the company’s earnings growth rate that will produce future capital appreciation and dividend income growth, if a company pays a dividend.

Sound valuation is primarily a measurement of risk associated with making a purchase of a common stock.  However, from a total return point of view, it is a relative metric that is best evaluated in conjunction with earnings growth.  Nevertheless, the proof is in the pudding as they say.  Therefore, I offer the following F.A.S.T. Graphs™ where I review several prominent well-known stocks in relation to the 15 P/E ratio as a standard valuation reference.  I will start out with the S&P 500, followed by several companies with various earnings growth rates.  The company examples are offered in order of lowest earnings growth rates to highest.

Continued on the next page.

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