Learning Outcomes, after watching this video you will be able to compare and contrast the PE and PEG ratios, define the market-to-book ratio, list the steps involved in valuation of multiples of comparable firms. The PEG ratio and other valuation multiples. A rule of thumb is that the PE ratio should be roughly equal to the growth in earnings or dividends. In other words, the ratio of the PE ratio to growth in earnings, which is called the PEG ratio, should be close to 1. The PE ratio for gender model stock is currently five. This suggests that gender models growth and earnings should be around 5% per year. Let's look at an example that helps us compare and contrast the PE and PEG ratios. There are two similar firms, Y and Z which are in the same industry. Both of them have the same dividend payout rate of 50% and the same expected return of 15%. However, Y has an earnings growth rate of 10% and Z has an earnings growth rate of 5%. Remember, the PE ratio based on fundamentals is the dividend payout rate or r sub e minus g. The PE ratio for y is 0.5 divided by 0.15 minus 0.10, which gives us 10. The PE ratio for z is 0.5 divided by 0.15 minus 0.05 which gives us 5. Which is the better buy, using the PE ratio? Since they are similar companies in the same industry, we can say that Z, with the lower PE ratio, seems to be undervalued, and should be the better buy. Even though Z has the lower PE ratio and seems to be the better buy, you can see that the growth rate of Z at 5% is lower than that of Y at 10%. So, is Z truly the better choice? The PEG ratio for Y is its PE ratio of 10 divided by its growth rate of 10 which comes out to 1. Similarly, you can show that PEG ratio of Z is also 1. Once we adjust for the difference in growth rates by calculating the PEG ratio, both appear to be priced correctly relative to each other. Let's change the example slightly to illustrate the impact of expected return on the PE ratio. Let's continue to assume that Y and Z have the same dividend payout rate of 50%. Both of them now have the same growth rate of 5%. Their expected returns are, however, different. Y has an expected return of 12% and Z has an expected return of 10%. Which is the better buy? The PE ratio for Y is 0.5 divided by 0.12 minus 0.05 which gives us 7.14. The PE ratio for Z is 0.5 divided by 0.10 minus 0.05 which is 10. This shows us that Y is relatively underpriced. Since the growth rates are the same for both, Y will also have the lower PEG ratio. The comparison of the PE or PEG ratios show that you should buy the relatively underpriced Y. Both our examples identify one of the stocks as undervalued relative to the other. In the first case, zero's undervalued because of its low growth rate. But should you really buy a low growth stock just because it has a low PE ratio? Once we adjust for the difference in growth rates using the PEG ratio we actually find that both are similarly priced. In the second example, Y had the lower PE ratio because it had the higher expected return. This tells us that companies that appear most undervalued due to low PE or PEG ratios may actually be the riskiest. These are some things to keep in mind while investing in low PE firms. Stocks appearing as bargain buys may actually not be good investments. As their growth rate may be too low or the risk may be too high. Under the valuation multiple is the book-to-market ratio that we saw earlier in the context of the Fama-French three-factor model. To make it look like a valuation multiple, let's take the reciprocal of this and use the market-to-book ratio. Again, comparable firms should have similar market to book ratios. Here are some important things to keep in mind about valuations using multiples. Make sure you define the multiple properly, because it can be defined in many different ways. Identifying an appropriate set of comparables as controlling for differences is quite difficult. Understand the cross-sectional distribution of the multiples before you decide if it is too low or too high. Also, understand what fundamentals drive the multiple. Identifying the exact stocks to invest in is part of the asset selection decision. This could be based on comparing your evaluation of the stock using the dividend discount models and or comparables valuation to the actual stock price. If the actual price is higher than what you have calculated then it is overvalued and you should sell it. If the actual price is lower than what you have calculated then it is undervalued and you should buy it. Once you have invested in the stocks how well do they perform? The final step in the investment process is to evaluate the performance of your portfolio, which we will look at next time.
