Reading 42: Market-Based Valuation: Price and Enterprise Val 2010, face, interpret, valuation, relative

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Session 12: Equity Investments: Valuation Models
Reading 42: Market-Based Valuation: Price and Enterprise Value Multiples

LOS o: Calculate and interpret the P/E-to-growth (PEG) ratio and explain its use in relative valuation.

 

 

 

Good Sports, Inc., (GSI) has a leading price-to-earnings (P/E) ratio of 12.75 and a 5-year consensus growth rate forecast of 8.5%. What is the firm’s P/E to growth (PEG) ratio?

A) 150.00.

B) 0.67.

C) 1.50.

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The firm’s PEG is 12.75 / 8.50 = 1.50.

 

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The relative valuation model known as the PEG ratio is equal to:

A) earnings per share growth rate / price-to-earnings.

B) price-to-earnings (P/E) / earnings per share (EPS) growth rate.

C) P/E × earnings.

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The PEG ratio is equal to the price-to-earnings ratio divided by the EPS growth rate.

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Which of the following statements regarding the P/E to growth (PEG) valuation approach is least accurate? The P/E to growth (PEG) valuation approach assumes that:

A) stocks with higher PEGs are more attractive than stocks with lower PEGs.

B) there are no risk differences among stocks.

C) there is a linear relationship between price to earnings (P/E) and growth.

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The PEG valuation approach implicitly assumes there is a linear relationship between price to earnings (P/E) and growth, even though there is not a "real world" linear relationship. The analyst must be cautious when using the PEG ratio for valuation or comparison purposes especially if the growth rate is very small or very large. If earnings or the growth rate is negative the PEG ratio is meaningless. The PEG ratio does not adjust for varying levels of risk among stocks and views stocks with lower PEG ratios to be more attractive than stocks with higher PEG ratios.

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The definition of a PEG ratio is price to earnings (P/E):

A) divided by the average growth rate of the peer group.

B) divided by the expected earnings growth rate.

C) divided by average historical earnings growth rate.

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The PEG ratio is P/E divided by the expected earnings growth rate.

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At a regional security analysts conference, Sandeep Singh made the following comment: "A PEG ratio is a very useful valuation metric because it generates meaningful results for all equities, regardless of the rate of dividend growth." Is Singh correct?

A) Yes, because the expected dividend growth rate is cancelled out in the computation of the PEG ratio.

B) Yes, because the computation of the PEG ratio does include the rate of expected dividend growth.

C) No, because the PEG ratio generates highly questionable results for low-growth companies.

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The PEG ratio measures the tradeoff between P/E and expected dividend growth (g). The formula for the PEG ratio is: PEG = (P/E) / g. PEG ratios generate questionable results for low-growth companies. Also, the PEG ratio is undefined for companies with zero expected growth (division by zero) or meaningless for companies with negative expected dividend growth.

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Two security analysts, Ramon Long and Sri Beujeau, disagree about certain aspects of the PEG ratio. Long argues that: "unlike typical valuation metrics that incorporate dividend discounting, the PEG ratio is unique because it generates meaningful results for firms with negative dividend discount growth prospects." Is Long correct?

A) Yes, because the expected dividend growth rate is cancelled out in the computation of the PEG ratio.

B) No, because the PEG ratio generates meaningless results for low-growth companies.

C) Yes, because the computation of the PEG ratio does not use the rate of expected dividend growth.

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The PEG ratio measures the tradeoff between P/E and expected dividend growth (g). The formula for the PEG ratio is: PEG = (P/E) / g. As such, firms with negative expected dividend growth will have a negative PEG ratio, which is meaningless.

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Consider the statement: "Unlike many valuation metrics that incorporate dividend discounting, the PEG ratio may be used to value firms with zero expected dividend growth prospects." Is this statement correct?

A) Yes, because the expected dividend growth rate is cancelled out in the computation of the PEG ratio.

B) Yes, because the computation of the PEG ratio does not use the rate of expected dividend growth.

C) No, because the PEG ratio is undefined for zero-growth companies.

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The PEG ratio measures the tradeoff between P/E and expected dividend growth (g). The formula for the PEG ratio is: PEG = (P/E) / g. Firms with zero expected dividend growth will have an infinite (or undefined) PEG ratio due to division by zero.