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PEG Ratios - Who uses them/how to use them effectively?


rockket
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Couldn't find anything on this topic - does anyone actively use PEG ratios in their analysis?

 

I'm relatively new to investing (and brand new to the board), and am still trying to wrap my head around growth and determining appropriate multiples/valuations behind them. I've seen people throw around PEG ratios here and there but never completely understand its rationale, or why it should approximate 1 at fair value.

 

I'd be interested to hear from anyone who has a real view on the matter (either for or against).

 

Thanks!

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PEG is one way of getting some company names to think further about.  And if there is enough history for a company to get a handle on past growth, PEG-type thinking  may be a guide to the future, to determine a reasonable buying price.  Those are two diffferent uses, notice -- one is preliminary screen for names for investigation, other is trying to estimate value long term of a single company.

 

For instance, a company that has been around for decades, earns about 10-15 pct of book annually, has been able to reinvest those earnings to grow the company, seems reasonably free of insider theft (aka misappropriation) of earnings/assets, does not make many stupid/egotistical mistakes (aka mismanagement), distributes 2 pct of book as dividends and hence grows at let's say 11 pct average/year.  To get a probable 10-years hence value of that company, first decide what the company is probably like in 10 years -- still in same business or not, still same good management (honest, competent) or not, etc...

 

Then, to the numbers.  With 10-year horizon, assuming 13 pct earnings/year, 2 pct paid as dividends.  Use a discount rate of 6 percent.  (Lower is just deluding oneself -- there is risk in allocating capital, regardless of whether market recognizes it at the present.  Within 10 years the risk will get recognized again.)

 

So, if believe that can see 10 years ahead, use 5 years horizon in calc for margin of safety.  If book is 100 today, expect it will be 100*1.11^10 in 10 years.  That's 284.  Discount at 6 pct for value of money.  Leaves 158 present value of future book.  Put in value of dividends, assuming no increase (margin of safety, not reinvested, increase only at discount rate) at 2/year, or add 20, to get 178 present value of future book + dividend stream.  Margin of safety on purchase -- nothing above 70 pct, so pay 125, or 25 pct above book.  If buying at 112, effectively using 5-year horizon for additional margin of safety.  Lower the buy price, the greater the margin of safety = how much of the future is being anticipated.

 

Wait until company falls into disfavour (it surely will) for buying opportunity.  I like to buy small position, to establish personal interest, and maintain familiarity with company over the years.  Then will get the rhythm and a feel for when to commit further.  Sort of like merging into traffic on freeway from the entry ramp.  Others with more discipline can watch without having any skin in game. 

 

I've got 100+ companies on the completed-analysis list, and hold meaningful positions in only 11 of them.  So that implies a lot of concentration in my stockholdings.  Cash is another 45 pct, but still it means 5-pct average position size if all were equal.  The other 90-some companies are just watch -- someday perhaps invest.  For one reason or another, they're not as well run, or otherwise appealing, as the others -- or price opportunity has never arisen.

 

As you can see, PEG is just one component, one wrench in the toolkit.  I'm no great shakes as an investor -- many (most) posters on this board have more skill, manage significant assets, etc.  The most important thing, I believe, is to develop a list of names on which one has completed at least rudimentary analysis, obtained some idea of fair price (don't want to pay at fair, though!) and the personality / dynamics of the business.  Best book to develop that sort of discipline, is Philip Fisher's.  Best book to learn analysis is Ben Graham's.

 

Best wishes,

ws

 

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