Using The PEG Ratio As A Valuation Tool

In my last few articles we have looked at several valuation metrics, using Caterpillar, Inc. (CAT) as an example. The final method will use discounted cash flow, but before that it is worth considering the PEG ratio â€“ price/earnings to growth. This has the advantage of being very easy to calculate.

When considering the PEG ratio, remember that it is considering a companyâ€™s future earnings, whereas P/E most commonly uses twelve month trailing earnings. To calculate the PEG, you simply divide the P/E by the anticipated growth in earnings. A value greater than one may imply that the stock is overvalued or that growth estimates are too low. If the value is less than one, the opposite applies â€“ the stock is undervalued or growth estimates are too high. The PEG ratio is very useful when one wishes to compare companies across different industries. It can also be used to compare the company you are looking at to the index they are listed on.

What are the issues with using the PEG ratio? The obvious one is the growth estimate. Generally, a five year growth rate is used as this may be more accurate than a one year estimate. As we know, there are many internal and external factors which will impact growth, therefore the longer the timeframe for the estimate the better. Secondly, and perhaps most importantly, if the company pays a large dividend, the PEG will be high, and may lead the potential investor to consider it overvalued. An example would be a utility, these are typified by solid earnings and good dividends, but earnings growth may not have much potential to improve. However, for the investor looking for high dividend yield stock, it would be ideal. Therefore, it is important not to overlook the dividend yield and it can be built into the denominator by adding it to the growth estimate. The PEG ratio is a useful tool in your analysis, and should be used with other valuation methods as opposed to stand-alone. In the context of CAT:

2013 P/E Actual1 : Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â  Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â Â  18.40

Long Term Earnings Growth Forecast (5years)2: Â  Â  Â  Â  Â  Â  Â  Â 10.2%

Dividend Yield3: Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  Â  2.78

PEG = 18.4/10.2

PEG = 1.8

*PEG (incorporating dividend yield)

18.4/ (10.2+2.78)

PEG = 1.4

From CATâ€™s investor relations4, we can see that there has been an increasing level of dividend pay-out over the last 21 years, and there has been a \$6.2bn repurchase over the last two years as the company states that it is focused on delivering good returns to its stockholders.

References:Â