Price-to-Earnings-to-Growth Ratio

If you don't know what the P/E ratio is, check out our opus. M. Night Shyamalan's finest work for us. Totally worth the million stock options we paid him for doing it.

So...price. You have Build-a-Boar stock trading at 40 bucks a share. It had net income, or earnings, last year of 2 bucks a share...and trades at, yes, 20 times earnings. So that’s P and E, or P to E. It trades at 20 times earnings.

What does that mean?

Well, if it held earnings flat for 20 years (and basically all of its earnings were cash earnings, not like some fancy accounting trick), the company would have made back all of its valuation in cash profits, and everyone would yawn. That company would have paid a 5 percent cash return yield: 2 bucks in earnings over 40 bucks a share, which is 5 percent.

Is that a good return? Bad return? Was there a lot of risk in that number? Growth? Um...shrinkage?

In a PEG ratio, earnings growth is taken into consideration.

So 20 times earnings is kind of a ho-hum multiple. But this company has no growth, so that 20 times is probably pretty high as a multiple, all things considered.

What if earnings were doubling each year for the next 5 years? Like...earnings went from 2 to 4 to 8 to 16 to 32 bucks a share?

Well, then 20 times earnings was ludicrously cheap. Growth was 100%. Versus that 0 percent, where 20x earnings looked…decent.

The basic idea (and this one is coined by Peter Lynch, the portfolio manager who brought Fidelity to fame) is that a PEG ratio of one means that a stock is fairly priced. That is, P/E ratios need context. Specifically, the context of earnings growth.

The formula takes the P/E ratio. Say it’s 20. And then puts it over the annual earnings per share growth number. And note that it’s per share, not just overall company earnings. Like, if a company grew earnings by acquiring for stock a lot of competitors, its share count would balloon while its earnings grew fast, i.e. the dilution it would suffer would mitigate most of the upside of the earnings growth.

So in our 20 times earnings number, a company with no growth gives us a PEG ratio of 20 over zero. Which is an undefined number. But a PEG ratio is all about how expensive the price to earnings ratio is...relative to the growth of the company.

Wow…we did not see that twist coming. Well done, M. Night.