Making the most of PEG as an investment measure

If I were asked to forsake all but one measure for valuing growth shares, I would want to retain the PEG factor. I admit that I would be cheating a little because it is really a combination of two measures - the price/earnings ratio and the growth rate.

Indeed, the PEG is obtained simply by dividing the prospective p/e ratio of a company by its estimated future growth rate.

Every active investor knows that companies with high growth rates merit high multiples. The question is how high, and that is where the PEG comes into its own.

A few months ago, I calculated that the average PEG for leading UK growth stocks was 1.2. A quick recent audit determined that the figure is little changed today. The average prospective p/e ratio for leading growth stocks is about 15.5 and their average annual growth rate is 13 per cent. As you can see, 13 divided into 15.5 results in an average PEG of 1.2.

In essence, the PEG tells you how much you are paying for growth. Last week, I wrote about Essex Furniture, which had a PEG of only 0.3, four times cheaper than the average leading growth share. Of course, Essex Furniture is a small and relatively obscure company that cannot really be compared with giant leading growth companies like Marks & Spencer and Vodafone. However, its nearest competitor, DFS Furniture, has a PEG of 0.85, so Essex Furniture's shares, at yesterday's price of 193p, still offer 21 4 times more future growth for your money.

A cynic might argue that you cannot compare Essex Furniture, which capitalises at a paltry pounds 22.5m, with DFS Furniture, which has a market capitalisation of about pounds 300m. However, I believe that small dynamic growth companies should command higher p/e ratios than medium-sized companies which, in turn, should have higher p/e ratios than leading companies. The reason is simple - elephants don't gallop.

Within a few years, it is almost an impossible task to double the earnings of a company capitalised at pounds 10bn. Many small dynamic businesses have little trouble doubling their earnings and, in some cases, repeat the exercise every few years until they become leading companies. That is when they begin to slow down.

Over the long term, it has paid to buy the market as a whole on a PEG of one or below. To illustrate this, it is obvious that a company growing at 15 per cent per annum on a multiple of 15 would be very appealing and at a growth rate of 20 per cent per annum, a multiple of 20 would also be very attractive.

Although the PEG is an invaluable investment tool, there are a number of important caveats to bear in mind:

The PEG factor is designed especially to measure growth stocks. It does not work well for recovery stocks, cyclicals and asset situations.

Frequently, it is difficult to distinguish between recovery and growth. For the PEG measure to work at its best, the figures should be based on sustainable growth or the expectation of it.

Coming out of a recession and with the benefit of devaluation, almost all companies are recovering to a greater or lesser extent. However, those with a record of consistent growth over the previous five years are very different from companies that have suffered a serious setback and are striving to recover to their former profit levels.

All other things must be reasonably equal. Although compromises are often necessary, ideally, the selected company should have a competitive advantage, strong cash flow, insignificant debt and positive news flow.

The PEG method of selecting growth stocks works at high levels of growth, but the dangers of high multiples are much greater. For example, a share growing reliably at 30 per cent per annum would, in today's markets, merit a p/e ratio of at least 30. The key point is that growth at such a high rate is not usually reliable, so the downside risk is increased. The effects of a change in news flow, even from excellent down to reasonably good, can have a disastrous effect on the price of a high-multiple stock.

The PEG measure works at its best with companies that have earnings growing at 15 per cent - 25 per cent per annum with p/e ratios within five points either way of the average. Based on the average prospective multiple of 15.5, the best and safest results would be obtained with growth stocks with p/e ratios in the 10-20 bracket.

PEGs are based on the consensus of estimates prepared by brokers. There may be differences in the methods of computing earnings used by some of their analysts.

The reliability of PEGs is much improved if a large number of brokers is covering the company and there is a low standard deviation. (The standard deviation indicates the extent of the deviation of individual estimates from the overall consensus figure).

If the company's tax charge is below normal, an adjustment should be made to establish the PEG on a normal tax charge.

In addition to helping to maximise the upside potential from a share, the PEG can also be used as a defensive measure. A company with a below-average PEG is obviously less vulnerable (all other things being equal) than a share with an above-average PEG. It is therefore worthwhile periodically calculating the average PEG of a growth portfolio to evaluate how defensive it would be in a bearish climate.

As with other investment criteria, the PEG cannot be considered in isolation. However, it is the single financial statistic that gives an instant fix on whether a growth share appears to be cheap or dear.

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