Summary of Einhorn Speech
In 2005, David Einhorn (Trades, Portfolio) gave a Value Investing Congress speech about how to properly use Peter Lynch's PEG Ratio. He explained that PEG ratio is simple defined, as calculating to numbers, first the trailing P/E ratio and second the expected earning growth rate for the next five years. You Convert the growth rate from percentage to an integer, so 10% becomes 10. Then you divided the convert growth rate by the P/E ratio and you get the PEG ratio. Einhorn goes own to explain why the pros money managers use the PEG ratio and how its quicker to use then discount cash flow. Which has made the PEG ratio the most common used ratio by Wall Street. He also goes own to explain some of the problems of the PEG ratio.
Problems of the PEG Ratio:
- First it doesn't tell you anything
- If a company has a PEG ratio of 3, You don't know if its cheap for expensive.
- Other measurements immediately tells you something
- PEG ratio of 1 means nothing
- PEG ratio doesn't distinguish between seculur or cyclical growth.
Einhorn explains how the PEG ratio does take into account different kind of growth in a company's earnings an doesn't distinguish between permanent expansion in earning power or growth that is short-term and supported by favorable cyclical tailwinds.
In the full speech he explains how PEG ratio leads to misvaluation of companies.
Value Investing Congress
November 15, 2005
Peter Lynch is one of the greatest investors of all time. As a professional investor he clearly had all the analytical skills to properly value stocks and identify superior opportunities. He combined smarts and energy to be one of the best stock pickers of a generation. He realized that non-professional investors who don’t have 100 hours a week to devote to selecting the best portfolio of stocks couldn’t do everything that he could and they may not have the access or technical skills that he did.
Nonetheless, he believed that he could contribute some basic investing skills to the average, or even above average, individual investor. So he wrote a best selling book called One Up Wall Street. I read it years ago. It was an excellent book. The thesis was that if you identify companies that are doing great on Main Street, you will do well with them on Wall Street.
My Grandma Cookie used to love to invest in stocks. This was the basic advice she followed. When she saw all her grandkids in NIKEs, she bought the stock. When she passed away a few years ago, I had a chance to look over her portfolio. She had done pretty well for a non-pro. She built a portfolio filled with blue chip growth companies like, NIKE, IBM, AT&T (when that was a good thing), believe it or not McDonalds and best of all WalGreens. She would buy these stocks bit by bit over decades and hold forever.
She did much better than my Grandpa Ben, who has spent most of his retirement constantly checking the markets. He subscribes to about a dozen news letters and cites the latest thinking of his favorite guru’s at all family events. He is a Goldbug and has been waiting for the economic ruin of our country through a paper money, deficit driven, hyper inflation at least since I was ten. Grandpa Ben decries our lack of sound money. Grandpa Ben owns gold bullion, gold stocks, mining companies, options on gold and gold stocks. Grandpa Ben is one of the best people I know, one of the nicest people I have ever met. But Grandma Cookie coming out of the Peter Lynch school beat the pants off him as an investor for thirty years. For individual investors, I would bet on Grandma Cookie’s style for the next thirty, as well.
Nonetheless, I digress. Coming back to Peter Lynch’s book, One Up Wall Street. It really tried to avoid a lot of technical valuation skills. He realized that those were either beside the point or likely beyond the attention span of the mass audience he was writing to. But he threw in a valuation hint, a rule of thumb if you will. He advised individual investors to pay just a little attention to the possibility that when you identify a company doing well on Main Street, take a moment to check to make sure that Wall Street hasn’t already figured it out. He advised investors to figure out how fast the company is growing its earnings and compare it to the Price/earnings ratio. If the PE ratio was greater than the growth rate, it was probably too late to join the party.
The wonder of this analysis is its simplicity. You can compare a growth rate with a PE ratio in about 5 minutes — or less. I don’t know if Grandma Cookie did this, but I know if she wanted she could. A good thing, too, because I’d bet Grandma Cookie had about the same chance of properly constructing a discounted cash flow analysis that I had of carrying on Robin Yount’s legacy as the star of the Milwaukee Brewers.
As best I can tell, Peter Lynch’s description is the genesis of the PEG ratio. What is the PEG ratio? Simply defined, you calculate two numbers. First the trailing PE ratio and second the expected growth rate of earnings for the next five years. Convert the growth rate from a percentage to an integer, so 15% becomes 15. Now divide the PE ratio by the growth rate and you have a PEG ratio. So a PE of 20 and a growth rate 10% gets you a PEG ratio of 2. A PE of 10 and a growth rate of 20% gets you a PEG ratio of one-half.
For today’s discussion, I am going to stick to this “classical” definition. I have seen ridiculous concoction of this ratio using three- year growth rates or forward PE ratios. Etc. I have seen analysis that says, this company is going to grow its earnings 40% next year to $1 so it should trade at $40 using a PEG ratio of 1. Obviously, this is a big problem, because even if the earnings grow 40% for 1 year, the following year may not be so good and a slightly lower subsequent growth rate, might lead to a lower stock price using the PEG methodology. Look what happens to this math when the earnings only grow 20% to say $.85…would that make the stock worth $17. So if you thought it was worth $40, a modest shortfall might cost you more than half your investment.
Picking on abuses of the PEG ratio is too easy. Everyone knows them when they see them. I’d like to spend a few minutes on the “classical” PEG ratio. This a ratio that is seldom analyzed but widely used. In fact, Merrill Lynch conducts an annual survey of professional money managers where they ask them what factors they consider when making stock selections. Mind you, these aren’t individuals. These are the Pros. The survey gives them 26 metrics to chose from: PE ratio, Price to Book, Price to Sales, ROE etc. According to Merrill Lynch’s 2003 survey, the number 1, most common used metric by Pros is the PEG ratio. In 2004 PEG fell to third, narrowly behind EPS surprises and Price to Cash Flow. Nonetheless, 43% of professionals admit to considering the PEG ratio when selecting stocks. In contrast, only 33% use PE ratios and only 25% use dividend discount models. There were 201 pros surveyed, with one-third foreign. PEG analysis appears to be disproportionately an American phenomena. Well over half the US participants use PEG and it was easily the number 1 factor used by American professionals.
Why do the Pros use it? I think for the same reason, Grandma Cookie might have used it: Because they can calculate it quickly. Pros are lazy just like everyone else. They are busy people with management meetings to attend and they’d rather get the answer quickly. You can get a PEG ratio much quicker than a well-conceived DCF valuation.
So since, this is the most commonly used ratio on Wall Street, I thought that while we are all here together today we could examine the PEG ratio’s theoretical underpinnings as they relate to finance theory.
There are none. Phew! That wasn’t hard.
Now let’s look at some of the problems with the PEG ratio. First, is that simply telling you what the PEG ratio is does not tell you anything. If a stock has a PEG ratio of 3, I don’t know if that means it is cheap or expensive. If the PE ratio is 60 and the expected growth is 20, I would conclude it is expensive and should be avoided. If the PE is 12 and the expected growth is 4, I would conclude it is reasonable. If the PE is 3 and the expected growth rate is 1, I would conclude that it is an obvious bargain, as paying 3 times earnings that are stable is a great way to make a fortune.
If you tell me any other measure, it immediately tells me something. A PE of 5 means something. 3 times book value means something. Ten times EBITDA means something. A PEG ratio of 1 means nothing.
Next, to the extent that there is a relationship between proper PE multiple and earnings growth, I would submit to you that it is non-linear. If you look at the capital asset pricing model, the theory for valuing perpetual growth is PE = 1/(r-g) where r is the cost of equity and g is the perpetual growth rate. If you were to try to graph this you would get an asymptotic curve. Now admittedly, the PEG ratio only purports to cover 5 years of growth, rather than through perpetuity. Nonetheless, it is a linear relationship. At best you are trying to fit a line through a curve. Any good 10th grader will tell you that would intersect the curve in no more than two points. In most places it is nowhere near the curve. It just gives you the wrong value.
Next, a PEG ratio does not tell you anything about the quality of the growth. Put simply, earnings growth happens three ways and they are of vastly different quality. The best kind of growth is organic top line unit growth. Companies that grow by doing more of whatever they do are the most valuable. Investors, can, should and do pay up for this kind of growth. It is generally hard to find and in the best cases, it is open -ended. What is the maximum number of sneakers for Nike, hamburgers for McDonalds or targeted adds on the internet for Google?
The next best type of growth is through margin expansion. Margin expansion is good. It rarely requires additional capital. Whether it comes from pricing power, economies of scale or cost cutting it is nice. The problem with margin expansion versus, unit growth, is it isn’t open ended. Most businesses can only improve margins to a certain extent. Eventually, they can’t push price, they operate at optimal scale and there is no fat left. Nonetheless, improving earnings through expanding margins is a good way to grow earnings for a period of time.
The third way, and least valuable, to create earnings growth is by leveraging the balance sheet. Sometimes this passes as top line growth through acquisitions or excess capital investment. Sometimes it comes from leveraged recapitalizations through one means or another or incrementally over time through share repurchases. However achieved, this form of earnings growth is least valuable. Not only is it inherently unsustainable – the growth rate, not the earnings – in that companies can only leverage to a certain degree, but such growth should be rewarded with a shrinking p/e multiple as the risk to the enterprise grows and the cost of equity correspondingly should increase.
It is true that sometimes the market doesn’t recognize the distinction and rewards this growth with an undeserved rich multiple. However, that is a difference between what the market should do versus what it does do. Smart investors can make the distinction and avoid paying up for situations like these where higher growth comes with higher risk. Personally, I like to sell short these type of situations.
That the PEG ratio doesn’t distinguish between types of growth is a tremendous flaw.
What is worse, it doesn’t distinguish between secular growth and cyclical growth. Secular earnings growth represents permanent expansion of earnings power. Cyclical growth represents temporary growth aided by favorable cyclical tailwinds. Just so we aren’t confused, cyclical growth can come from either a favorable macro environment or a favorable circumstance for the company at hand, such as a hot product. Obviously, secular earnings growth that sustains itself at growing levels ought to be rewarded with a much better multiple than growth aided by cyclical or temporary factors.
When you put all this together, it isn’t even clear to me that higher earnings growth should always be rewarded a higher multiple. Sometimes it should be rewarded with a lower multiple. I would take this to the point of arguing that if you have two companies at 15 times earnings and one is expected to grow 15% for the next five years and the other is expected to grow 10%, it isn’t entirely clear to me that the 15% grower should get ANY premium over the 10% grower. It all depends on the circumstances.
If you agree with me on this, the only thing to conclude is that the PEG ratio has no value and is never genuinely informative in determining valuation.
PEG adherents will invariably respond to such criticism by claiming that the PEG ratio isn’t the “only” thing they look at. I, of course, respond, “Yes, but why do you use it at all?”
The PEG ratio leads to the systemic misevaluation of companies. This creates opportunities for investors who use sound valuation technique. The way to make a lot of money using the PEG ratio is to allow others, including a lot of lazy Professionals, to use it.