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

The 15 P/E Ratio As A Standard Valuation Reference

In order to illustrate the validity of a 15 P/E ratio as a benchmark valuation reference, even over different earnings growth rates, I offer the following simplified graphs.  There are only three lines on each graph.  The bright pink line represents a P/E ratio of 15 across the entire graph.  The dark blue line represents a calculated normal P/E ratio for each example.  There is no dividend information included in these graphs because the exercise is designed to evaluate valuation based on earnings as represented by the price-to-earnings ratio.  Finally, the black line plots monthly closing stock prices over the timeframe graphed.

What I am asking the reader to notice is how the price line relates to the 15 P/E ratio benchmark over time.  There are times when the price will be above the 15 P/E ratio benchmark, and times when the price will be below it.  However, a close examination of each graph should clearly illustrate the validity of the 15 P/E ratio benchmark.  It is obviously not a perfect relationship; however, it should be clear that the 15 P/E ratio represents a valid valuation benchmark on each example.

There is another important takeaway that I would like to focus the reader’s attention on.  The 15 P/E ratio benchmark clearly illustrates sound valuation.  However, the slope of each line is equal to the respective growth rate of each example.  Therefore, even though sound valuation is indicated by the same 15 P/E ratio, long-term price action is determined by the growth rate of each company (the slope of the line).

S&P 500 Index

When reviewing the overall stock market as represented by the S&P 500 index, we discover a valuation range between a P/E ratio of 15, and the normal P/E ratio of 17.6.  Additionally, we see that the average earnings growth rate of the S&P 500 since 2001 has been 5% per annum.  Nevertheless, the monthly closing stock prices of the S&P 500 correlate very closely to where earnings have gone.  More importantly, we see that having the discipline to invest in the S&P 500 when its P/E ratio was at or below the 15 P/E ratio benchmark represented optimum investment opportunities in the index.

Verizon Communications Inc. (NYSE:VZ)

Verizon Communications Inc. (NYSE:VZ) has the lowest earnings growth rate of any of the samples I will be presenting.  Since 2001 Verizon Communications Inc. (NYSE:VZ)’s average earnings growth rate has been 1.9%. Nevertheless, the validity of the 15 P/E ratio as a fair valuation reference is clear.  Whenever price gets above that valuation reference it moves back into alignment and vice versa.

Southern Co (NYSE:SO)

My second example looks at Southern Co (NYSE:SO), which also has a very low earnings growth rate of only 2%.  However, with this example, earnings growth has been more consistent.  Once again, we see how the stock price wants to gravitate to the 15 P/E ratio fair valuation reference.

Genuine Parts Company (NYSE:GPC)

With my Genuine Parts Company (NYSE:GPC) example I present a company with a similar earnings growth rate of 4.8% similar to the S&P 500 earnings growth rate of 5%.  Once again we see the validity of the 15 P/E ratio as a standard valuation reference.  The reader should note how relevant the pink 15 P/E ratio line is as a valuation standard over this long time frame.