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You may have heard of something called the "peg ratio," which is defined as a company's price to earnings ratio divided by its growth rate. Supporters of this concept claim that a stock is fairly valued when its "peg ratio" is equal to 1; this, however, is inaccurate. Let's examine why.
In our explanation of Return on Capital and Return on Equity, we introduced a chain of 20 lemonade stands named "the Jack Company." It has a net income of $10,000 and a return on equity of 20% (and since the company has no debt, its return on capital is also 20%). We said that the Jack Company could add $1000 to its annual income if it built two more stands, and to do so would require an investment of $5,000. Should the Jack Company build these two lemonade stands?
Suppose that the Jack Company decides not to grow its business. Instead, it will pay its entire $10,000 in income to its shareholders in the form of a dividend.
Let's also suppose that I can buy a bond, named bond XYZ, that will give me an 10% interest rate. If the Jack Company pays me $10,000 in cash, I can buy $10,000 of XYZ bonds; next year, these bonds will pay me $1,000 in interest.
Next year, however, the Jack Company decides to build 4 lemonade stands, which will cost $10,000; it's free cash flow will be 0, and its return on equity will be 20%. Using these numbers, we can predict that the company's earnings will grow by approximately 20%.
So, The Jack Co now owns 24 lemonade stands instead of 20, and its net income has increased from $10,000 to $12,000. Thus, next year, the company is able to pay $12,000 instead of $10,000 to its shareholders as a dividend. By investing $10,000 in its business, shareholders are getting $2000 in additional dividends every year; but if the shareholders buy XYZ bonds, they only get $1000 in interest every year. Thus, the Jack Company has created value by investing in its business.
Suppose the Jill Company also decides not to grow its business. Instead, it will pay $10,000 in income to its shareholders. If the shareholders then invest in XYZ bonds, they will also earn $1,000 in total interest.
Next year, however, the Jill Company decides to build 1 lemonade stand, which will cost $10,000.
The Jill Co now owns 21 lemonade stands rather than 20, and its net income has increased from $10,000 to $10,500. Thus, next year, the company is able to pay $10,500 instead of $10,000 to its shareholders as a dividend. By investing $10,000 in its business, shareholders are only getting $500 in additional dividends every year. Yet, they earn $1000 in interest if they bought XYZ bonds. So, the Jill Company destroys value whenever it expands; shareholders would be better of if the Jill Company paid out all of its income in the form of a dividend.
This is one reason why the "Peg Ratio" is an inaccurate measure. If a company earns low returns on capital, it will not create any long term value regardless of how quickly it appears to be growing. On the other hand, a company that earns high returns on capital will create lots of shareholder value even if it's growth rate is slow. Companies that earn high returns on capital deserve to trade at a much higher P/E ratio than companies that earn low returns on capital. Conversely, you should not invest in any company that earns very low returns on capital.
There's another reason to ignore the peg ratio - a company that will grow for a long period of time deserves to trade at a higher P/E ratio than one that will grow for only a few years. If a company is growing at 15% per year, but its market is nearly saturated, it does not deserve to trade at a high P/E ratio. (Note: it is risky to project high growth far out into the future. No matter how great the company, 15% growth over 10 years is almost impossible to achieve. Some companies accomplish this, but it is difficult to predict in advance which companies will show this rate of growth.)