Investors are much more concerned about the future than the past. Companies that currently make a lot of money will have that fact baked into their market price by investors. Appreciation in investor value comes from (market expectations) of future growth. Expectations of near-term growth don’t help much because those are already baked in as well. The only growth that helps investors in the short term is when an earnings report beats expectations. Value investors seeking to invest in a business rather than a stock can profit from growth beyond the time horizon where Wall Street is willing to look.
One way to summarize the growth prospects of a company is to examine the ratio of Price/Earnings to Growth (PEG). This is a difficult metric to write about since it involves taking one ratio and forming another ratio with it. It makes more sense to experienced investors since we tend to think of a P/E ratio as a single thing, which we often refer to as the multiple. The PEG ratio, then, is the multiple divided by the growth of a company’s profits over a given period. One reason that we would want to do such a thing is that the multiple itself can be misleading. Value investors are looking for stocks that sell cheap, but that is only half of what they are after.
Computing Earnings Growth
Earnings growth is a hugely important metric for all investors. This growth is usually expressed as a percentage. To compute the growth rate of a company, take the most recent earnings per share (EPS) and divide that by the EPS for the last quarter (or year, depending on your preference), then subtract one from that. This results in a proportion, which you can convert to a percent by multiplying by 100. For example, if a company reports earnings of $2.00 per share and then reports earnings of $2.50 per share then next quarter, we can compute the earnings growth as:[($2.50 / $2.00) – 1] * 100 = 25%
What the value investor is really looking for are good companies selling at a low price. Value investors don’t put much stock in the efficient market idea, at least in the short term. Value investors believe that Wall Street can go nuts and pay excessively for stocks, and they can have huge sales for no good reason. Wall Street can also be rather sensible at times and refuse to pay up for terrible companies. The trick to value investing, then, is to identify companies selling at a discount to their true value and ignore companies that are truly terrible and have low P/Es because of that.
If we assume that the SEC and the rest of the regulators are protecting us from “irregular accounting practices,” we can assume that a company that has a track record of growing profits quarter over quarter is doing something right (Enron is a good example of when this assumption fails). Wall Streeters will pay up for good earnings, but they will pay up even more for earnings growth.
The PEG ratio is a way to look at both ideas at once. The lower the PEG ratio, the more undervalued a company may be given its earnings performance. To get data to plug into this ratio, we can simply look at past performance to compute a trailing PEG ratio. The problem with this is that we fully expect growth to grow or diminish over time; it almost never sits still. Some investors will use the forward PEG ratio, which is computed based on predictions about what earnings will look like in the near future.