Analysis of the PEG ratio and income yield
Updated
In this idea I’ll be covering two valuation metrics the PEG ratio and the income yield here is the PEG ratio:
The PEG ratio (price earnings growth ratio): This is another very popular ratio and it is calculated by dividing the share price by the product of the eps and the annualised eps growth rate. There are many different types of PEG ratios, and the annual eps growth rate can be over the course of a different number of years, it could be for 1 year, or even 10 or more. However, it is most common to find the annual eps growth rate over the past 5 years. It is also worth noting that you can have a forward PEG ratio, just like you can have a forward P/E ratio, however, I would prefer to use past earnings as they have actually materialised and therefore are more reliable.
The main advantage of the PEG ratio is that it will tell you how much you will be paying for the earnings over time, so whilst a company may look expansive on a P/E ratio now, if it is quickly growing over time the P/E ratio will be looking smaller and smaller and may even be considered cheap when it was once expensive. A PEG scored 1 is considered average and the lower the PEG score, the better, you are paying less for the total earnings. Unlike the P/E ratio, you can more comfortably compare the PEG ratio across different sectors as the sectors with more growth potential will have that more priced in with the PEG ratio. However, whilst the PEG ratio has numerous advantages there are also several drawbacks.
1. A one off charge or gain could mean that the earnings and growth of a company could be depressed or inflated, giving it a PEG score that is too low or too high, when in reality this one of charge will have little to do with what the earnings will be in the future.
2. The PEG score does not include cash conversion rate, a company could have high and rising earnings, but if this is not converted into cash it is difficult to envisage a scenario where the company generates value for the shareholders, or alternatively earnings could start to fall off as the company does not have as much cash to fund growth.
3. The PEG ratio does not give a far representation of cyclical shares, for example during a temporary downturn a company could have a high P/E and a low eps growth rate, but this is actually not an issue of a company it is just a common fluctuation. On the flip side during the upturns the company could have a low P/E and a very high eps growth rate, but this is actually not to do with the company itself.
4. The PEG ratio does not factor in how much debt or cash the group is carrying. A a company can enjoy the dual effect of increasing eps growth and earnings by simply acquiring another profitable corporation. The end effect is that without the company performing well itself a company can have a very low PEG as a result of higher eps and higher growth. So it makes sense that a company with net cash should be rewarded with a higher PEG than one which is highly leveraged as the group with net cash can expand more easily. However, the PEG ratio does not factor this in.
5. The PEG ratio also seems to favour companies with extremely high growth rates. The issue is that if a company has growth rates of 100% or more, the growth is likely to fall off quickly and so the company could look cheap on the PEG ratio, when in reality it is actually expensive. To deal with this I would recommend valuing a eps growth rates over 100% as 100% meaning that no company can have a PEG ratio of 1 or lower with a p/e of over 100.
Then there is also the issue of diluted and basic EPS. As stated previously in the P/E article I would recommend using diluted EPS. I would recommend using diluted eps for both parts of the PEG ratio, I.e diluted eps for the earnings and growth parts of the ratio.
This is the income yield:
The income yield: This is the same as the P/E ratio, except it is calculated as a yield, to convert from the P/E ratio to the income yield find the reciprocal of the yield and multiply it by 100%. Since we are using the reciprocal this time, the larger the yield the better, as you are recovering a higher percentage of your earnings each year. (Complete analysis on the P/E ratio is already on TradingView see link at the bottom)
The income yield, has the same limitations and advantages as the P/E ratio, except for the fact that it can be compared against other sources of income such as cash or bonds. It is worth noting that there are several other things to bear in mind apart from the yield when you are planning an investment. Firstly, the risk matters, you should generally expect a higher return from a riskier asset than a safe one, otherwise why take the risk? Secondly, it is also worth bearing in mind that the yield of an asset can fluctuate the yield can fall or hopefully, it should rise, and so it is worth paying a premium if the actual yield is likely to increase over time.
The PEG ratio (price earnings growth ratio): This is another very popular ratio and it is calculated by dividing the share price by the product of the eps and the annualised eps growth rate. There are many different types of PEG ratios, and the annual eps growth rate can be over the course of a different number of years, it could be for 1 year, or even 10 or more. However, it is most common to find the annual eps growth rate over the past 5 years. It is also worth noting that you can have a forward PEG ratio, just like you can have a forward P/E ratio, however, I would prefer to use past earnings as they have actually materialised and therefore are more reliable.
The main advantage of the PEG ratio is that it will tell you how much you will be paying for the earnings over time, so whilst a company may look expansive on a P/E ratio now, if it is quickly growing over time the P/E ratio will be looking smaller and smaller and may even be considered cheap when it was once expensive. A PEG scored 1 is considered average and the lower the PEG score, the better, you are paying less for the total earnings. Unlike the P/E ratio, you can more comfortably compare the PEG ratio across different sectors as the sectors with more growth potential will have that more priced in with the PEG ratio. However, whilst the PEG ratio has numerous advantages there are also several drawbacks.
1. A one off charge or gain could mean that the earnings and growth of a company could be depressed or inflated, giving it a PEG score that is too low or too high, when in reality this one of charge will have little to do with what the earnings will be in the future.
2. The PEG score does not include cash conversion rate, a company could have high and rising earnings, but if this is not converted into cash it is difficult to envisage a scenario where the company generates value for the shareholders, or alternatively earnings could start to fall off as the company does not have as much cash to fund growth.
3. The PEG ratio does not give a far representation of cyclical shares, for example during a temporary downturn a company could have a high P/E and a low eps growth rate, but this is actually not an issue of a company it is just a common fluctuation. On the flip side during the upturns the company could have a low P/E and a very high eps growth rate, but this is actually not to do with the company itself.
4. The PEG ratio does not factor in how much debt or cash the group is carrying. A a company can enjoy the dual effect of increasing eps growth and earnings by simply acquiring another profitable corporation. The end effect is that without the company performing well itself a company can have a very low PEG as a result of higher eps and higher growth. So it makes sense that a company with net cash should be rewarded with a higher PEG than one which is highly leveraged as the group with net cash can expand more easily. However, the PEG ratio does not factor this in.
5. The PEG ratio also seems to favour companies with extremely high growth rates. The issue is that if a company has growth rates of 100% or more, the growth is likely to fall off quickly and so the company could look cheap on the PEG ratio, when in reality it is actually expensive. To deal with this I would recommend valuing a eps growth rates over 100% as 100% meaning that no company can have a PEG ratio of 1 or lower with a p/e of over 100.
Then there is also the issue of diluted and basic EPS. As stated previously in the P/E article I would recommend using diluted EPS. I would recommend using diluted eps for both parts of the PEG ratio, I.e diluted eps for the earnings and growth parts of the ratio.
This is the income yield:
The income yield: This is the same as the P/E ratio, except it is calculated as a yield, to convert from the P/E ratio to the income yield find the reciprocal of the yield and multiply it by 100%. Since we are using the reciprocal this time, the larger the yield the better, as you are recovering a higher percentage of your earnings each year. (Complete analysis on the P/E ratio is already on TradingView see link at the bottom)
The income yield, has the same limitations and advantages as the P/E ratio, except for the fact that it can be compared against other sources of income such as cash or bonds. It is worth noting that there are several other things to bear in mind apart from the yield when you are planning an investment. Firstly, the risk matters, you should generally expect a higher return from a riskier asset than a safe one, otherwise why take the risk? Secondly, it is also worth bearing in mind that the yield of an asset can fluctuate the yield can fall or hopefully, it should rise, and so it is worth paying a premium if the actual yield is likely to increase over time.
Note
Please note that when I refer to the yield I mean the actual yield that you are receiving and not the percentage yield as it is not always good news if the percentage yield rises, as it could be the case that the investment falls in value and thus driving up the yield received.Note
Another drawback of the PEG ratio:6. The PEG ratio, does not reward companies that use their profits for things other than growth. For example, a company could decide to use the profits for the year to pay out dividends or reduce debt*, both of these are very sensible things for management to do and provide benefits for the shareholders, however these do not create eps growth. So it is worth paying attention if the company is paying a dividend and wether debt levels are rising or hopefully falling.
* Please note that debt reduction will change eps slightly and almost always cause it to increase as they have to pay less interest on its loans (unless there are negative interest rates), however the difference is likely to be minimal.
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