Saturday, July 29, 2006

PEG Stands for Purely Esoteric Garbage

PEG is completely worthless piece of information in analysing a stock. Its The relation to price and earning is non linear. First look at the DCF equations would tell you that. You would have used DCF models. Just plot a graph on the DCF valuation and different values of expected growth. Notice the curvature of the graph. You will see that any approximation of this curve using a straight line plot will lead you to huge errors.

PEG comes handy when you have to convince yourself to buy a stock which has cought your fancy. The decision has been made but the rational mind requires justification. In comes PEG. At stock growing at 20% available at PEG of only 1. Utter bullshit!

PEG would give you wrong result even if your growth estimation was correct. If you are ready to tolerate bit of maths then here is why I'm saying this.

Suppose PEG is a constant.

P = P/E * E
P/E = PEG * growth
P = PEG * growth * E

Suppose you have 3 companies with EPS, of Rs. 1 per year.

  1. Available at price 100, expected to grow at 3%
  2. Available at price 300, expected to grow at 9%
  3. Available at price 900, expected to grow at 27%

PEG of all these choices are same. Suppose you invest Rs. 9000 in each of these companies. Lets also assume that your prediction about growth was correct. Now see what happens in the 20th year from now.

  1. Earning 157.8, accumulated profit 2418.3
  2. Earning 154, accumulated profit 1534.8
  3. Earning 938, accumulated profit 4375

Earnings = EPS* no. of shares

In hindsight company C was obviously better choice than A but A was significantly better than B. Why did we get this bizarre result? This is because PEG is a variable. Its different for each combination of price and growth.

Mathematically PEG is a slope of the curve plotted between growth and P/E applicable for that growth. When you compare PEG of two different companies then you are assuming that linear relationship between growth and P/E and you would get wrong results here even when you correctly predict the growth.

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1 comment:


When it comes to stock investing information overload is the key word.