The PEG Ratio: A Winning Factor in Investing

by | Oct 29, 2003

Time, as I exhort young investors, is the single most important factor in stock market success. But you can own a stock for 100 years and, if it doesn’t increase its profits at a nice annual clip, you’ve got a depleting asset on your hands. The winning formula is time plus growth. A stock with […]

Time, as I exhort young investors, is the single most important factor in stock market success. But you can own a stock for 100 years and, if it doesn’t increase its profits at a nice annual clip, you’ve got a depleting asset on your hands. The winning formula is time plus growth.

A stock with earnings that rise consistently at a rate that’s a good deal higher than inflation will be an enormous winner over time — thanks to the power of compounding, which Einstein called the most powerful force in the universe. A company that earns $1 million today and increases those profits at an annual rate of 15 percent will earn about $4 million in 10 years and about $64 million in 30 years.

If the stock’s price rises at roughly the same rate (as it probably will), then you’ll make 64 times your money in a generation. If inflation is 2.5 percent during the period, then your purchasing power increases by a factor of about 30. Not bad at all.

There’s only one problem with growth: It’s no secret. Most investors understand just how valuable it is, and they price the stocks of growing companies at a premium.

Consider Whole Foods Market (WFMI), which owns and operates a chain of 143 natural-foods supermarkets. Whole Foods has increased its earnings at an average annual rate of 13 percent over the past five years, and analysts surveyed by Yahoo Finance expect 20 percent growth for the next five.

As a result, Whole Foods is much loved by investors, who have bid its price up from $8.80 a share in 1997 to $59.71 today. The price-to-earnings (P/E) ratio for Whole Foods is 36 and change. By contrast, Weis Markets (WMK), a solid chain with average earnings growth for the industry (an expected 6.5 percent annually for the next five years) trades at a P/E of just 16.

Or look at another measure of valuation: the price-to-sales (P/S) ratio. For Whole Foods, it’s 1.1; for Weis, 0.5. In other words, investors are willing to pay more than twice as much for every dollar of earnings and of revenue that Whole Foods generates in comparison with Weis.

Why? Because Whole Foods is increasing its earnings and its revenue so fast that the higher valuation — the more expensive price — appears worth it. Last year, Weis earned $2.10 per share. The Value Line Investment Survey projects it will earn $2.70 five years from now. Whole Foods earned only $1.40 per share in 2002, but Value Line projects earnings of $3.25 in five years. In 1997, Whole Foods earned one-third less than Weis; in 2008, it’s projected to earn one-fifth more. That’s the result of time plus growth.

It’s not a shock that high growth equals a high price — or, more accurately, a high valuation such as P/E or P/S. Investors like growth so much that they sometimes go a little crazy. Recently, cited such stocks as Monster Worldwide (MNST), the online employment agency, with an estimated growth rate of 24 percent and a P/E of 68, and Tibco Software (TIBX), with projected growth of 25 percent and a P/E of 69, as examples of “paying too much for growth.”

Sometimes, however, you run across stocks with high growth but relatively low prices. In other words, potential bargains, often big bargains.

One way to detect those bargains is through a quick-and-dirty indicator called the PEG ratio. It’s calculated by dividing a stock’s P/E ratio by its estimated annual earnings growth.

Again, take Whole Foods. Its P/E is 36; its estimated growth rate is 20 percent. Divide 36 by 20 and you get 1.8. Monster and Tibco have PEGs of 2.8. The rule of thumb is that a PEG of 1.0 or less signals that a stock may be undervalued. The average PEG ratio for the stocks of the benchmark Standard & Poor’s 500-stock index right now is 1.4.

The PEG ratio is far from perfect. First, it’s based on earnings, or profits according to generally accepted accounting principles — figures that, as I have pointed out before, are easily manipulated. In addition, companies with heavy capital requirements need to reinvest their earnings, so there’s little cash left over for shareholders. Second, the earnings are projected — that is, they’re guessed at.

Still, the PEG ratio can flag stocks that are worthy of further study and possible investment, and a PEG used with other indicators can be exceptionally valuable.

Value Line, for example, recently screened its universe of stocks to find top PEG companies with additional attractive attributes. The 18 companies that qualified had PEGs of less than 1.0 based both on actual earnings for the past five years and on projected earnings for the next five. They also had to rank at least average (“3” in Value Line’s system) for timeliness, or likelihood of strong price appreciation; rank at least B-plus for financial strength; have an average annual growth rate of 15 percent for the past five years; and carry a P/E that is equal to or less than the current Value Line median.

The winners included five health care companies, five financials and three home builders. Among the more intriguing were Lennar Corp. (LEN), which both builds houses and finances them and carries a PEG (using projected earnings), according to the Oct. 3 Value Line Investment Survey, of just 0.66; TJX Cos. (TJX), clothing retailer, with a PEG of 0.91; WellPoint Health Networks (WLP), managed care, 0.72; AutoZone (AZO), auto-parts retailer, 0.89; Steven Madden Ltd. (SHOO), shoes, 1.0; New York Community Bancorp (NYB), 0.76; MBNA (KRB), credit cards, 0.78; and American Woodmark (AMWD), kitchen cabinets, 0.84.

These companies are not merely bargain-priced; they’re excellent businesses. Lennar, for instance, has a top timeliness rank (“1”), a P/E of just 9 and a projected growth rate of 15 percent (which is half the rate of the previous five years).

TJX carries an A-plus rating for financial strength and has been producing a return on capital of more than 25 percent. MBNA, also rated A-plus, has a P/E of 16 and pays a decent dividend (yielding 1.7 percent) to boot. New York Community, the Queens County Savings Bank, looks like a real sleeper. It has shown powerful growth lately.

By the way, Yahoo Finance ( is one of several Web sites that report PEG ratios for all stocks. The Motley Fool site has a “Pegulator” that lets you calculate the PEG on your own (

The October issue of Better Investing, the magazine for members of the National Association of Investors Corp., the investment-club organization, carries another list of screened stocks for PEG lovers. This one also uses Value Line data. Stocks had to pass four tests: (1) they must be projected to double earnings in the next five years; (2) they must have actually doubled earnings in the past five years; (3) they must sell at P/E ratios that are 110 percent or less of their projected earnings growth rates; and (4) they must have safety ratings of average or better.

The first two criteria establish that these are indeed growth stocks — increasing their earnings at about 15 percent annually, or twice the average historic rate for the market. The third establishes that the companies have PEGs that are lower than average. The fourth shows that the firms are relatively secure. Only 43 companies passed all the tests.

There was overlap with the Value Line PEG list, of course (including WellPoint, MBNA, AutoZone, New York Community and TJX). Health care dominated here, with 13 stocks, and there were strong showings again by financials and home builders.

The revelations were companies in the food business: Hain Celestial Group (HAIN), a small-cap maker of natural and organic foods under such brand names as Health Valley and Celestial Seasonings, with a PEG of 1.1; Constellation Brands (STZ), marketer of alcoholic drinks in North America, Europe and Australia, 0.87; Sonic Corp. (SONC), a drive-in hamburger chain, 1.1; and Brinker International (EAT), a global owner of such mid-range restaurants as Chili’s, Maggiano’s Little Italy and Corner Bakery Cafe, 0.97.

Other notable stocks on the list were Armor Holdings (AH), which makes protective armor for police and military clients and carries a PEG ratio of 1.2 with a projected earnings growth rate of 17 percent, and K-Swiss (KSWS), fast-growing maker of athletic footwear under various labels, including National Geographic.

A few words about high rates of earnings growth: They don’t last. They can’t.

Consider Johnson & Johnson (JNJ), a great company that last year earned about $8 billion after taxes. Over the past 10 years, the firm’s profits have grown at 13.5 percent annually, and Value Line expects growth of 12 percent for the five years to come. But imagine that rate continues, not for just five years, but for 30 years. J&J’s earnings would reach $250 billion. Even discounting for inflation, that’s an enormous number — five times as much as General Electric (GE), the world’s most profitable industrial firm, earned over the past five years!

In our book “Dow 36,000,” economist Kevin Hassett and I developed estimates of earnings and stock prices far into the future by assuming that companies experienced a life cycle. Many that grew swiftly as adolescents would inevitably slow down as they matured.

It’s an article of faith among economists that a company that is exceptionally profitable will attract competitors, which will, at the very least, whittle down its growth rate. As a result, my ideal company has a PEG of 1.0 or thereabouts and a growth rate that’s not too luscious — say, around 12 percent to 15 percent.

There are, alas, few such gems, and nearly all carry special risks. Washington Mutual (WM) is one. It has a P/E of 10 and an estimated earnings growth rate of 12.5 percent. It is also under investigation by the Texas attorney general for suspect mortgage-lending practices. (Let me say quickly that I own the stock, understanding that it is no slam-dunk.) Another is Toll Brothers (TOL), a large home builder with a P/E of 11 and a projected growth rate of 13 percent. The problem here: Interest rates have fueled a boom in housing, but what happens if they revert to the mean and rise significantly?

A third is Honda Motor Co. (HMC), with a P/E of 11 and expected growth of just under 14 percent. But is the Japanese recovery (not to mention the U.S. recovery) for real?

There’s no free ride in investing, so don’t peg all your hopes on low PEGs. Use them as one indicator — and a very good one — among many.

Among the stocks mentioned in this article, James K. Glassman owns MBNA, General Electric and Washington Mutual.

Ambassador Glassman has had a long career in media. He was host of three weekly public-affairs programs, editor-in-chief and co-owner of Roll Call, the congressional newspaper, and publisher of the Atlantic Monthly and the New Republic. For 11 years, he was both an investment and op-ed columnist for the Washington Post.

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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