Jack's PEG & ROI Calculator Explained
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.)
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.
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.
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.
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.
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