Why I’m Afraid of Bullish PEGs

The PEG ratio compares a stock’s price (as measured by the price-to-earnings ratio or P/E) with its earnings growth. When used correctly, PEG can help you find great companies.

But I suspect that these days it’s misused more often than not.

P/E is one of several metrics that can help you get a handle on how expensive or cheap a company is. A PEG of 1 or less means good growth for the price. Above that, and the stock is probably overvalued.

I used to love PEGs of 1 or less. Whenever I saw one, I wrote in the margins of my notebook, “High growth expected.”

Two years ago, this notation always meant “Good. The company is on a high-growth trajectory.” When I write the same thing now, it means something entirely different. I think, “Gee, can this company meet its high-growth expectations?”

Let’s take a look at Coke.

The forward P/E (based on expected earnings for the next 12 months) for the entire S&P 500 index is 12.42. Coke’s is 13.02.

If Coke were expected to increase earnings at a rate of 13.02 percent a year over the next five years, its PEG (P/E divided by earnings growth) would be exactly 1.

With a 13.02 P/E, the last thing I want is a PEG of 1 or less. In such a case, the company would be expected to grow earnings by at least 13.02 percent a year. And in this global environment, that would be next to impossible.

But Coke’s PEG isn’t 1. It’s 1.69. That makes its projected annual earnings growth a very achievable 7.7 percent.

The stock market is all about expectations. When a company disappoints analysts and investors, it can lead to a decrease in its share price.

With a PEG of 1 or less, that’s a probable outcome these days. I don’t go there anymore – and neither should you.

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