Lenny Dykstra on finding a stock’s PEG
Lenny Dykstra, the former Major League Baseball star, is a financial wiz these days with a column at TheStreet.com and everything. He offers a primer on adding a growth component to a stock’s price/earnings ratio to get a better idea of a stock’s potential momentum.
When you add the growth trajectory to a P/E, what you get is a PEG ratio: a P/E multiple divided by its expected rate of earnings growth. A stock is generally considered to be fairly priced when its P/E ratio equals its growth rate, which works out to a PEG ratio of 1 (for example, a P/E of 10 divided by an EPS growth rate of 10% equals 1). A PEG ratio below 1 is considered undervalued. The lower the PEG the better, as long as it’s not in negative territory.
You have to rely on companies’ and analysts’ estimates of forward earnings to arrive at the PEG, so it’s a bit of a crapshoot (as is every other data point in isolation), and it’s especially rough sledding in times like now, when so many companies are lowering their profit estimates. You can’t calculate Price/Earnings/Growth if there’s no growth. How does Cat fit in?
In this recession, we’re seeing many companies predict lower total sales for 2009. For a company whose earnings will drop, the PEG ratio becomes meaningless. For example, Caterpillar has a forward P/E of 8.9. But its consensus 2009 EPS estimate is about 20% lower than 2008 earnings. Dividing P/E by a negative growth rate gives a negative PEG number that is not useful.
The reality is that Caterpillar’s earnings outlook is unclear, and an expected revenue drop could be offset next year by a big federal infrastructure spending package once President-elect Obama takes office.
Dykstra shows how it works by crunching numbers for a couple tech companies with actual growth estimates for next year.
You don’t have to do the math yourself: Yahoo’s stock screener, for example, includes PEG. Interestingly, very few stocks have a PEG under 1, according to Yahoo’s screener, suggesting either a) the screener is wrong; b) stocks are still overpriced despite the fall crash; or c) everybody’s earnings are falling next year so their PEGs are negative.