Posted by Prem on Thursday, April 21, 2011 | Tags : Equity Valuation
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PEGY ratio stands for Price Earnings to Growth Rate and Dividend Yield ratio. It is pronounced as peggy ratio. It is a variation of P/E ratio, which is used for valuating companies which pay substantial dividends and have earnings growth rate.
The companies with higher growth rate will be having higher EPS leading to higher P/E ratio in comparison to industry P/E. However, higher growth rate companies also associate themselves with the high growth risks. Due to higher P/E, investors generally don't invest in those companies and miss the opportunity to earn from multi-bagger stocks. Another major problem with P/E ratio is that it doesn't take into consideration of the earnings growth rate of a stock. Institutional investors are willing to invest in those stocks which are growing. Some of the well informed investors will use either PEG ratio to valuate growth companies as it factor in growth rate.
PEG ratio can be used for valuating companies with higher growth rate, but is gives misleading results when used for high dividend paying companies or lower growth stocks paying dividends. PEG ratio also doesn't take into consideration of the impact inflation or interest rate on earnings growth rate.
There are some other school of thoughts also. Companies with lower earning growth rates will have a higher PEG ratio and some of the investors invest in them. In contrast, the general thumb rule of PEG ratio say that lower PEG ratio stocks are relatively undervalued and higher PEG ratio stocks are relatively overvalued. Some investors present their views that higher earnings growth is associated with higher risk and non stability of earnings. A lower earning growth rate company will have lower risk and a stable earnings. So investors pay premium for investing in them.
It is advised that investors should use PEGY ratio for valuating companies having substantial dividend paying records or lower earnings growth rate stocks
PEGY ratio = Price to earnings ratio divided by growth rate and dividend yield
PEGY ratio tells us that how much the market is willing to pay for each unit of earnings growth rate and dividend yield. A stock with PEGY ratio of less than 1 is considered to be undervalued and a stock with PEGY ratio of more than 1 is considered to be overvalued.
For example, if a company has a P/E of 20 and estimated annual earnings growth rate is 5%, and it pays a 5% dividend, the PEGY ratio would be 20/ (5+5) = 2.
In contrast, the PEG ratio would look a lot more expensive at 4 (20/5).
This shows that PEGY ratio is more appropriate for valuing a low growth stock paying dividends as compared to PEG ratio.
Investors should use normalized EPS for calculating PEGY ratio. Normalized EPS doesn't take into consideration of one time charges and unusual charges. If normalized EPS is not been used, then the PEGY ratio will increase and lead to biased results.
The growth rate of a company is not the representative of overall economy. For example, if a company's earning is growing at 10% and the overall economy is growing at 15%, than the stock is not a good buy as its growth rate is lower than overall economy growth rate.
It is said that dividend paying stocks are the best stocks to invest and hold as they create value for the investors over a longer period of time. Generally, the dividend paying stock have higher earnings growth rate as compared to non-dividend paying stocks. The retained amount which is used for reinvestment into projects, should be checked for profitability. If the projects are profitable, than the stock with lower PEGY ratio is a good candidate for investment.
Investors should try to identify those stocks which have lower PEGY ratio, higher earnings growth rate than overall economy growth rate and having a higher dividend yield. However, PEGY ratio is calculated on the basis of forecast of growth rate and dividend yield, so the more accurate the projection, the more accurate will be the PEGY ratio results. PEGY ratio is purely a quantitative measure and it doesn't take qualitative measures like management quality, competitive forces in the market, corporate governance, social responsibility and ethics of the company.