Beware the PEG Ratio

The PEG ratio is a simple tool that can be useful for finding undervalued stocks. But don't let it be a shortcut for your own homework.

The PEG ratio takes the PE ratio one step further by factoring in earnings growth. In short, companies with faster earnings growth warrant higher P/E ratios.

This metric was first popularized by Peter Lynch and is calculated as:

Price/Earnings/Growth

According to Lynch, a company that's fairly priced will have a P/E ratio equal to its growth rate. In other words, a stock with a PEG ratio of 1.0 is fairly valued, while a stock with a PEG ratio of less than 1.0 is undervalued and a stock with a PEG ratio greater than 1.0 would be overvalued.

Not So Fast

While this seems incredibly simple and intuitive, remember it is only a rule of thumb. The assertion that a P/E ratio should equal earnings growth is somewhat arbitrary and certainly does not apply to all companies.

Consider a blue chip company operating in a mature industry. Its earnings growth may only be 5%. Does that mean it should have a P/E ratio of 5? What if it pays a huge dividend? What about a company with no growth?

The intrinsic value of a business is the total of all its free cash flow available to owners discounted to the present value. Of course, that can be extremely difficult to calculate with any accuracy. So the PEG ratio is simply a proxy for it, and nothing more.

There is also no consensus on whether to use a trailing or a forward P/E ratio and whether to use next year's expected growth rate or a 5-year expected growth rate.

Beware Those 5-year Growth Rates

I would argue for using the longer-term growth rate to keep a long-term perspective, but I recommend using it only with a great deal of caution. That is because the long-term earnings growth rates that analysts publish are often overly optimistic.

A study by professors at Penn State's Smeal College of Business showed that over a period of almost 20 years, analysts' long-term EPS growth forecasts averaged 14.7%, but companies actual long-term EPS growth averaged only 9.1%.

One reason for this is because analysts almost never forecast negative long-term EPS growth, although it happens quite frequently. Another is because sell-side analysts are much more concerned about forecasting earnings for the next one or two years than forecasting what the average earnings growth rate will be over the next five years.

So do your own homework. Make sure the growth rate seems reasonable. Because many bad investment decisions have been made based on off-the-wall earnings growth projections.

3 Deceiving PEG Ratios

So what are some deceptively attractive PEG ratios out there right now? Here are 3:

Sonic Corporation (SONC - Snapshot Report)

PEG Ratio: 0.9
5-Yr Projected EPS Growth: 14.1%

What happened to this unique fast-food company? Sonic was growing rapidly throughout most of the last decade, and then the Great Recession hit. It hasn't really recovered yet.

Comps have been disappointing, earnings estimates are plunging, and earnings "growth" has averaged -19% over the last 5 years. Average EPS growth of 14.1% per year for the next 5 years seems like a long shot for Sonic, especially in the highly-competitive quick service restaurant industry. They'd have to right the ship very quickly to see that kind of growth.

Diodes Inc. (DIOD - Snapshot Report)

PEG Ratio: 0.8
5-Yr Projected EPS Growth: 18.0%

Diodes Inc. manufactures and sells discrete and analog semiconductors for the consumer electronics, computing, communications, industrial, and automotive markets. Earnings have been volatile, but the company has managed solid growth over the last several years. But that doesn't mean it will continue into the future.

Although analysts project 18% annual EPS growth for the company over the next 5 years, consensus estimates are calling for a -15% decline this year and a -7% decline next year due in part to margin compression and soft demand in China. And consensus estimates have fallen sharply over the last several months. It is a Zacks #4 Rank (Sell) stock. Seems like the long-term growth estimates need to come down too.

Diamond Offshore Drilling (DO - Analyst Report)

PEG Ratio: 0.8
5-Yr Projected EPS Growth: 16.0%

Diamond Offshore Drilling is an offshore contract driller with natural gas and oil rigs around the world. Sounds like a good place to be, but analysts are projecting flat to declining revenue over the next few years and -7% EPS growth this year and -23% next year. How in the world are they supposed to get to +16% average EPS growth from there in just a couple of years?

The Bottom Line

The PEG ratio can be a useful rule of thumb for finding undervalued securities. But it should only be a starting place in that search. Don't blindly rely on those published 5-year growth rates and do your own homework!

Todd Bunton is the Growth & Income Stock Strategist for Zacks Investment Research and Co-Editor of the Reitmeister Value Investor.