Using PEGs for growth comparison

While many investors focus on P/Es, the PEG ratio is a better growth indicator.

Summary: High price to earnings multiples can signal that a company is expensive based on its share price relative to earnings per share. But comparing the P/E ratio in relation to forecast earnings per share (EPS) growth rates can present a completely different picture of a company’s investment opportunity.
Key take-out: Focusing on a company’s PEG ratio and the security of earnings forecasts are vital criteria when analysing small capitalisation stocks with longer-term earnings uncertainty.
Key beneficiaries: General investors. Category: Shares.

In recent times news headlines have regularly suggested the possibility of a broader market correction after many months of rising share prices.

At the index level, the ASX200 is trading on a price earnings multiple of 15 times consensus estimates for FY15 – an approximate 10% premium to long-term averages.

With this average P/E ratio at a premium to long-term averages, many market commentators have suggested we are at risk of a further 5-10% correction.

In regards to stocks that could be sold down with further market weakness, there is little doubt that those with high P/E ratios are some of the first candidates that come under pressure.

Obviously, as well as the P/E ratio, the other critical factor is the perception of how secure forecasts earnings are. That is, a low-risk company having say 80% of revenues locked in by an annuity stream versus a high-risk company whose earnings are highly dependent on macro-economic conditions.

With this in mind, and digging deeper to the individual stock level, it is my view that rating a stock on a one to two-year P/E basis is too simplistic. This leaves a conundrum on how to value small caps, where there is large uncertainty of earnings forecasts more than two years out.

One answer to this problem is to compare the P/E ratio in relation to the forecast earnings per share (EPS) growth rates. It is commonly known as the PEG ratio – that is, the P/E divided by the forecast EPS growth rate.

A discounted cash flow valuation is more relevant for larger mature companies where you can forecast longer-term earnings with greater certainty.

With small caps the uncertainty of longer-term forecasts is often high. While this could be viewed as a challenge, it is often an opportunity. As many small caps are undiscovered by broking analysts and the broader market, it can result in greater upside when an opportunity has been identified. That is especially the case when you find a good business with low earnings risk and have high confidence in management’s ability to achieve high EPS growth rates over the next one to two years.

One rule of thumb is to look for small caps with a PEG ratio of 0.5 or less – that is companies where the EPS growth rate is at least double the P/E. It is even better if the earnings forecast is a base case with large upside potential. Finding companies in this position adequately accounts for the longer-term risk of earnings uncertainty.

Without making recommendations, and purely as an exercise of displaying the difference between a standard P/E ratio and a PEG ratio, I have looked at the high P/E companies within the ASX300 with a market capitalisation below $1 billion. I am relying on consensus analyst earnings for the FY14 and FY15 EPS growth.

The first table below displays the companies in order of lowest to highest FY14 P/Es.

P/E Comparison

Share Price

FY14 P/E

FY15 P/E

Company

Code

Treasury Group

TRG

9.12

14.9

13.8

Ridley Corp

RIC

0.87

15.5

13.8

Slater & Gordon

SGH

4.49

15.9

13.2

Kathmandu

KMD

3.44

16.6

14.4

Virtus Health

VRT

7.37

17.9

15.8

Ardent Leisure

AAD

2.47

18.4

16.3

SAI Global

SAI

4.16

18.7

16.3

GWA Group

GWA

2.85

18.9

15.8

ARB Corp

ARP

11.89

20.5

18.0

Amcom Telecom

AMM

2.01

20.7

17.8

ERM Power

EPW

2.43

22.1

15.7

Bega Cheese

BGA

4.95

23.1

20.5

Mayne Pharma

MYX

0.85

26.6

19.3

Vocus Communications

VOC

4.33

27.4

19.3

Corporate Travel

CTD

6.37

29

23

Greencross

GXL

7.74

31.2

24.1

Sirtex

SRX

15.38

36.4

28.4

IProperty Group

IPP

2.52

86.9

40

Note: Data as at April 15, 2014

The next table looks at the same stocks in regards to the best to worst FY14 PEG ratios.

PEG
Company

Code

Share Price

FY14 P/E

FY15 P/E

FY14 EPS

FY15 EPS

FY14 PEG

FY15 PEG

Growth

Growth

$

X

X

%

%

X

X

Virtus Health

VRT

7.37

17.9

15.8

132

13.3

0.14

1.19

IProperty Group

IPP

2.52

86.9

40

-

117

-

0.34

Ardent Leisure

AAD

2.47

18.4

16.3

50.6

13.4

0.36

1.21

Treasury Group

TRG

9.12

14.9

13.8

33

8.2

0.45

1.68

Mayne Pharma

MYX

0.85

26.6

19.3

50

37.5

0.53

0.51

Corporate Travel

CTD

6.37

29

23

38.4

25.5

0.76

0.90

Vocus

VOC

4.33

27.4

19.3

35

41.8

0.78

0.46

ERM Power

EPW

2.43

22.1

15.7

23.6

40.9

0.94

0.38

Bega Cheese

BGA

4.95

23.1

20.5

24.4

13.1

0.95

1.56

Greencross

GXL

7.74

31.2

24.1

32.6

29.4

0.96

0.82

Slater & Gordon

SGH

4.49

15.9

13.2

16

21

0.99

0.63

GWA Group

GWA

2.85

18.9

15.8

18.9

19.2

1.00

0.82

Ridley Corp

RIC

0.87

15.5

13.8

-

12.5

-

1.10

Sirtex

SRX

15.38

36.4

28.4

29

28

1.26

1.01

ARB Corp

ARP

11.89

20.5

18.0

-

13.4

-

1.35

Amcom

AMM

2.01

20.7

17.8

14.1

16.5

1.47

1.08

SAI Global

SAI

4.16

18.7

16.3

8.3

15.3

2.25

1.07

Kathmandu

KMD

3.44

16.6

14.4

1.8

15.6

9.22

0.92

Note: Data as at April 15, 2014

What becomes clear when comparing the two tables is that just because a company has a low P/E doesn’t mean it ranks well on the PEG analysis.

Possibly the best example of this is IProperty Group (IPP). Many would instantly dismiss the stock trading on a FY15 P/E of 40. However, while trading on an expensive FY15 P/E multiple, it actually has the most favourable FY15 PEG multiple of 0.34 due to the 117% forecast FY15 EPS growth.

The three stocks without FY14 PEGs or EPS growth rates (IPP, RIC, ARP) are recovering from an FY13 loss.

There are many successful companies that trade on a one to two-year P/E premium due to the market’s confidence of the company’s ability to achieve sustainable high EPS growth rates. One clear example from the list above has been Greencross (GXL) – its strategy of acquiring earnings accretive veterinary clinics has been a very successful long-term story. The share price rise from below $1 to above $8 has occurred despite its one to two-year P/E trading at a large market premium for much of this time.

The other companies trading near or below my target 0.5 PEG ratio are Virtus Health (VRT), Ardent Leisure (AAD), Treasury Group (TRG), and Mayne Pharma (MYX).

In conclusion, our message is to not only look at the P/E ratio. Instead, a focus on the PEG ratio and the security of earnings forecasts are vital criteria when analysing small capitalisation stocks with longer-term earnings uncertainty.