Jack's PEG & ROI Calculator Explained

 
USING JACK'S PEG AND ROI CALCULATOR

Hi friend. I know you're eager to start using Jack's PEG and ROI Calculator, but please take the time to read the following explanation and example first. You'll better understand how to get the most out of the calculator.

I hope you'll also read the two very short articles after the explanation:

           "The Deep Logic of PEG"  
                      and
          "Implications and Limitations of PEG Analysis." 

Note that underlined terms are fully explained in the Glossary.

What Is PEG and Why Should You Use It?

PEG stands for price/earnings-to-growth ratio. It is a stock's price/earnings ratio divided by its yearly growth rate. It is a measure by which you can judge if a stock's P/E and price are reasonable for its growth rate.

As you can see by what happened with the dotcom debacle recently, too many people buy stocks without having any idea of what the underlying business is really worth. It is only when the valuation bubble bursts that they realize how foolish they've been.

But smart investors don't have to try to guess how far a mania will go and when it will end in order to evaluate an investment. By calculating a stock's the PEG, and its expected return on investment (or ROI) you have a basis for objective evaluation of a stock's worth.

Calculator Instructions

A stock's PEG and projected ROI are easily found with Jack's PEG and ROI Calculator. You just enter the stock's price and its earnings estimates for this year and next year. (If you don't know these figures, I have set up a link, right on the calculator page, where you can get them.) The Calculator is set up so that you can calculate one stock or compare two stocks at the same time. 

What Section One of the Calculator Tells You

The first thing the calculator shows is the stock's current P/E ratio. Next, it shows the expected earnings growth, year-over-year, as a percentage. Then, it shows the price/earnings-to-growth ratio. The lower the PEG ratio, the bigger the bargain you're getting. It is the true test as to whether a stock is expensive or not. This will become obvious in the second section of the calculator, which shows you the projected return on your original investment in future years.

Here's an example:

Stock A
Stock Price $18.00
This Year's Earnings $2.00
Next Year's Earnings $2.25
P/E Ratio Equals 9.0
Growth Rate Equals 12.5%
PEG Equals 0.7
Stock B
Stock Price $18.00
This Year's Earnings $0.37
Next Year's Earnings $0.46
P/E Ratio Equals 48.6
Growth Rate Equals 24.3%
PEG Equals 2.0

Low PEGs Are Better

The low PEG of 0.7 shows Stock A to be a great bargain and Stock B to be expensive, despite its much higher growth rate. The shortened version of the ROI calculator displayed below shows why. The ROI, (sometimes called earnings yield) on your investment is much higher on a year by year basis, and cumulatively.

Looking at year 10, for instance, you can see that Stock A has a 36.1% return on your original investment while Stock B only returns 18.1%. More importantly, Stock A has a cumulative return on investment of 224.7% by then, whereas Stock B only returns 82.2%. Even after 20 years of much higher growth, Stock B has still not nearly matched the ROI of Stock A.

(Explanation continued below table.)

Stock A After
Year
No.
Stock B
Yearly
Earnings
ROI in
This Year
Cumulative
Earnings
Cumulative
ROI
Yearly
Earnings
ROI in
This Year
Cumulative
Earnings
Cumulative
ROI
$2.2512.5%$2.2512.5%1$0.462.6%$0.462.6%
$2.5314.1%$4.7826.6%2$0.573.2%$1.035.7%
$2.8515.8%$7.6342.4%3$0.714.0%$1.749.7%
$3.2017.8%$10.8360.2%4$0.884.9%$2.6314.6%
$3.6020.0%$14.4480.2%5$1.106.1%$3.7320.7%
$6.4936.1%$40.45225%10$3.2618.1%$14.7982.2%
$11.7065.0%$87.33485%15$9.6953.9%$47.66265%
$21.09117%$171.81955%20$28.80160%$145.29807%

Note that you can use the calculator to experiment with different earnings surprise scenarios and see how they affect your return. You simply use the input boxes to enter higher or lower earnings than the analysts predict.

Projected Stock Price

The third section of Jack's PEG Calculator is the projected stock price feature. It is extremely useful in gauging the future price of your growth stocks, given different scenarios. This function is explained fully right on the Calculator page.

You are now almost ready to use Jack's PEG and ROI Calculator, but before you do, I hope you'll read the following two very short articles. They will help you to become a better investor in general and to better understand and use the calculator in particular.

THE DEEP LOGIC OF PEG

When is a great stock too expensive, and when is a troubled stock a great buy? Simply knowing a stock's price and P/E is not enough to judge its value, since obviously a company whose earnings are growing very fast deserves a higher P/E than one growing slowly. So, you need a deeper understanding to evaluate a growth stock.

Look At It Like Buying A Business. You Are!

Buying a stock is just the same as buying a business. Would you pay $800,000 for a pizzeria that was earning $10,000 a year? Not likely. Well, that's exactly what you're doing when you buy a share of stock with a P/E of 80. You're paying 80 times its recent yearly earnings. You're just buying your proportionate share of the earnings instead of all the earnings.

Since $10,000 only represents a one-and-one-quarter percent first year return on $800,000 (10,000 divided by 800,000 = .0125 or 1.25%), you wouldn't lay out that kind of money unless you felt very sure earnings were going to grow at an extraordinary rate. That's why the PEG is so important. You have to be able to calculate what growth is worth, because eventually, a stock's price moves proportionately to the return on investment the company is earning.

Calculate To Evaluate

The PEG calculation is the great equalizer. By dividing the P/E by the growth rate, you can fairly compare and evaluate the prices of stocks, regardless of their P/Es. Calculating the PEG is pretty simple. If a company has a P/E of 20 and a growth rate of 10%, it would have a PEG of 2 (20 divided by 10). If it has a P/E of 75 and a growth rate of 25%, it would have a PEG of 3 (75 divided by 25), etc.

The PEG method works well to compare company valuations, regardless of stock price or P/E, as long as a company has earnings. Stocks with lower PEGs are better buys than those with higher PEGs. You're better off buying slower growth at a bargain price than buying high growth at an exorbitant price. The return the company earns internally on your investment will be higher, and that should eventually be reflected in the stock price.

IMPLICATIONS AND LIMITATIONS OF PEG ANALYSIS

I could have just made a simple 4 line calculator to give you the PEG, but you wouldn't really get an idea of what that implies for the long-term value of your investment. That's why Jack's PEG and ROI Calculator shows the projected earnings and return on investment for many years into the future. By showing the actual earnings your investment is expected to accumulate over a period of years, you can make a rational decision on evaluating it in comparison to other investments. Plug in a few numbers, and you'll begin to get the picture quickly.

Growth Rate Predictability

Obviously, for this valuation method to work out in the long run, the earnings projections must be reasonably accurate. Significant earnings surprises to the upside or downside will change the outcomes. This, however, is true of virtually any valuation method, so mentioning it here is not to say it's a drawback, but merely to remind you of this fact.

Usually earnings growth rates are more predictable with slower growing companies than with very fast growers. Also, keep in mind, especially with fast-growing high-tech companies, that the farther into the future you go, the more likely it is that something will come along to derail the earnings scenario. 

Psychological Factors

Why is it then that some stocks sport very high PEGs for extended periods of time? The answer is that many psychological factors go into a stock price along with the real economic factors. Sentiment is the biggest mover in the short term, whereas perceived stability and predictability of earnings can be a big long-term price booster.

GE, for example, has long had a PEG that was out of proportion to its growth rate. However, its growth has been so consistent over such a long period of time that people are willing to accept an implied lower rate of return in exchange for the their belief that reasonably good growth is almost guaranteed. The same feeling applied to Coca-Cola for a long time, but in recent years, it has not met expectations and has gone pretty flat.

Keep in mind when using PEG that since it makes a rational economic evaluation, it may take some time for this valuation to be reflected in a sentiment driven market. In the short term, sentiment rules, but economics eventually prevail. As Warren Buffett's mentor, Ben Graham, said, "The stock market is a voting machine in the short term, but a weighing machine in the long term." Personally, I'd rather be waiting with an asset I know has real value, than be holding one whose value is based solely on volatile market sentiment.

Now click here to go back to Jack's PEG and ROI Calculator.

 

   
Copyright 2008 by Jack Adamo. All rights reserved.