The Price-to-Earning to Growth ratio, commonly referred to as the PEG ratio, is a simplistic valuation rule of thumb. A value less than one potentially indicates an undervalued stock and a ratio greater than 1 might indicate overvalued stock. This simplistic and somewhat controversial ratio was popular in the ’90s but has more recently grown out of favor . The PEG ratio is calculated as follows:
PEG = PE ratio / Earning per share growth estimate
There are many versions of the PEG ratio based on different methods used to estimate earnings per share (EPS) growth rates. The PEG ratio version used for this backtest uses past 12 months earnings and and next year’s EPS consensus estimate whenever possible.
Let’s take a look at a backtest of this ratio to see how it works. I used the data and backtesting tool provided by Portfolio123. The Portfolio123 backtesting eliminates the problem of survivorship bias by using point-in-time and retaining data on stocks that have gone to zero. This backtest uses the same filtered universe of stocks as my recent Current Ratio Backtest. I’ve designed the filtering criteria for this backtest specifically for individual investors and with a focus on enhancing data quality. The filters include the following criteria:
- No OTC stocks. Stocks not traded on the New York Stock Exchange, NASDAQ, or American Stock Exchange markets are excluded. The quality of fundamental stock data for OTC can be somewhat lower and less timely that that for stocks traded on major exchanges.
- No ADRs. Fundamental data for foreign American Depositary Receipt can include errors due to currency exchange, different accounting standards, and share count.
- Liquidity test. The average daily total amount traded over the past 60 trading days must be larger than $100,000. This amount was selected so that a $1 million dollar portfolio could hold 100 positions and that each new $10,000 position would not exceed 10 percent of a day’s trading volume. The liquidity test also ensures that the backtest has reliable market price information for any of the stocks that are being tested.
- Market Cap > $50 million. Nano cap stocks are excluded to help improve data quality. This filter also ensures that positions in a modest sized portfolio never exceed one percent of shares outstanding or the available float for a company.
- Price > $1. True penny stocks are excluded due to various information issues and manipulation of these stocks.
- PEG ratio > 0. This filter insures we are looking at stocks that actually have valid data on the PEG ratio.
After these filters are applied, we are left with approximately 1,800 to 2,700 stocks. These stocks are then ranked by the criteria being tested; in this case, we are testing the PEG ratio. The lowest 20 percent of stocks ranked by the PEG ratio are placed in the first quintile and the next 20 percent in the second quintile and so forth until we have five portfolios of stocks. The portfolios are rebalanced every 12-months and compounded annually to more realistically replicate what an individual investor might be expected to do to avoid higher short-term capital gains tax and trading costs. The following 5 charts display the quintile returns for the PEG in red and the S&P 500 Equal Weight Index in blue. The first quintile includes the companies that had the lowest PEG ratios and the 5th quintile includes the companies that had the highest PEG ratios.
PEG Ratio Quintile Returns – 2000 – 2013
Summary of Results for the PEG Backtest
This backtest of the PEG ratio reveals that the first quintile outperforms the S&P 500 Equal Weight Index benchmark. The second through fifth quintiles have lower average annual excess returns than each of the previous quintiles and the overall trend in excess returns is a linear decrease as the PEG ratio increases. These results are as you would expect. The main issue to note with this fundamental ratio is that the change in excess returns from the 1st to the 5th quintile is not as dramatic as the PE ratio, return on enterprise value or the enterprise value to EBITDA backtests.
What are your thoughts on the PEG ratio?