Investment: It all hangs on a cheap PEG

LAST week, I explained my method of selecting great growth shares, bar the most important criterion of all - how to make sure that you buy the future growth cheaply. To explain how to do this, we need to go back to the basics.

The earnings of a company are the net profits after tax attributable to ordinary shareholders. If a company has earnings of 10p per share and a p/e ratio of 10, the shares would be priced at pounds 1, and with a p/e ratio of 20, the shares would be pounds 2. The annual rate of growth in earnings and the projected future rate of growth are the main factors that determine the multiple. The p/e ratio is the measure of how much you are paying for future growth and how much others have paid before you.

Earnings are the engine that drives the share price. If the engine fails or falters the shares will come down. The two charts show, at a glance, the close relationship between the earnings and the share prices of Marks & Spencer and Tesco over the past 15 years. There can be no doubt that earnings per share growth and the performance of share prices are umbilically linked, although there may be long periods during which they get out of kilter.

The average historic p/e ratio of the FT-500 Index on 1 March was 17.82. This figure is, however, made up of a hotchpotch of recovery stocks, cyclicals, growth shares, utilities, oil and property companies and financials. We are interested only in growth shares, so I have extracted from the FT-SE 100 Index almost all of our leading growth shares.

There are a few omissions - for example, Racal has been left out because of complications in the calculations arising from the Chubb spin-off, and Hanson, Guinness and Cadbury Schweppes have been excluded because of temporary setbacks in earnings.

I have also approximated financial periods. If a financial year ends in, say, March 1994 or even August 1994, the 12 months ending on those dates would be the basis for calculating the prospective p/e ratio. My figures are based upon brokers' consensus profit forecasts taken from the February edition of The Estimate Directory.

As you can see, the average FT-SE 100 growth stock is forecast to grow at 13 per cent in the year ahead. A very disappointing figure bearing in mind the benefits of devaluation. The average prospective multiple is 15.5. Investors are therefore prepared to buy the average leading growth stock on a prospective p/e ratio of 1.2 times the forecast growth rate. I will refer to this figure in future as the Price Earnings Growth (PEG) factor - an invaluable standard against which to measure share selections.

When you find a growth share that meets my other criteria, check the brokers' future consensus forecast. This will, in turn, enable you to calculate the prospective p/e ratio and the growth rate for the year ahead. Then express the multiple as a factor of the growth rate by dividing the growth rate into the multiple:

Of course, I realise that in the Mid-250 Index and below, some growth stocks are available much more cheaply. However, as the FT-SE 100 stocks account for about 70 per cent of the market capitalisation of all UK stocks, I feel that a PEG of 1.2 is a good enough measure of how much most investors are prepared to pay for growth.

Needless to say, our aim is to improve upon 1.2, so let us see how Amersham International measured up, when I recommended the shares two weeks ago. At the time, the prospective p/e ratio was 17.5, with a forecast growth rate of 40 per cent for next year. The PEG factor was therefore a mouth-watering 0.44. Even if Amersham settles down, after the benefits of devaluation, to a less demanding 20 per cent growth rate, it would still have an attractive PEG of only 0.88.

It is important to grasp that the PEG works on a sliding scale. You need not be frightened of high p/e ratios, provided they are supported by confident forecasts of exceptionally high future growth. If a share is growing reliably at 20 per cent per annum, you should not be surprised to see a price earnings ratio in the region of 24 (1.2 x 20).

In this market, you should be searching for medium-sized to large companies with PEGs of under one, and for smaller companies with PEGs of under 0.75. The beauty of this approach is that not only do you obtain the benefit of future growth, but you also reap rewards from the eventual status change in the multiple.

For example, a gem of a company, with earnings of 10p a share on a multiple of 13 and a share price of 130p, might be growing at 20 per cent per annum. When earnings are reported duly up 20 per cent, EPS would rise to 12p. Analysts would begin to realise that the company should be on a multiple of at least 20 and the shares would move up to 240p. Out of the rise of 90p, only 26p would be due to the rise in earnings. The far larger balance of 64p would come from the status change in the p/e ratio, with more to follow from that source as the shares continue to be better appreciated by investors.

The added advantage of buying shares on cheap PEGs is that you have a very comfortable cushion against unexpected setbacks. For example, if our gem of a company growing at 20 per cent per annum reported earnings up only 15 per cent, the shares would still be inexpensive. Even with average growth of 13 per cent, they would not be dear.

Now for the bad news - there are very few shares that fulfil my demanding criteria and can also be bought on low PEGS. However, you do not need many, we have the whole wide world to choose from, and we have plenty of time. So watch this space.

The author is an active investor who may hold any shares he may recommend in this column. Shares can go down as well as up. Mr Slater has agreed not to deal in a share within six weeks before and after any mention in this column.

----------------------------------------------------------------- FT-SE 100 GROWTH COMPANIES ----------------------------------------------------------------- Company Mid-Feb Financial Consensus Historic Prospective PEG share year growth p/e ratio p/e ratio factor price (p) ending in eps (%) Rentokil 214 12/93 18 27.4 23.3 1.3 J Sainsbury 568 3/94 14 20.0 17.6 1.3 Tesco 254 2/94 10 12.2 11.0 1.1 Argyll 380 3/94 10 14.2 12.9 1.3 Glaxo 655 6/94 16 16.7 14.4 0.9 Wellcome 863 8/94 18 18.3 15.5 0.9 SmithKline Beecham 469 12/93 14 17.2 15.1 1.1 Reuters 1409 12/93 14 23.0 20.2 1.4 Vodafone 397 3/94 10 18.5 16.8 1.7 Tomkins 256 4/94 15 18.7 16.3 1.1 Marks & Spencer 338 3/94 9 19.3 17.7 2.0 Inchcape 576 12/93 13 19.4 17.1 1.3 BTR 565 12/93 13 17.5 15.5 1.2 Grand Metropolitan 450 9/94 9 14.0 12.8 1.4 Great Universal Stores 1644 3/94 8 13.2 12.2 1.5 Unilever 1150 12/93 16 17.3 14.9 0.9 Rothmans 614 3/94 11 13.2 11.8 1.1 Thorn EMI 853 3/94 14 16.6 14.6 1.0 Average 13 17.6 15.5 1.2 -----------------------------------------------------------------

(Graphs omitted)