Abstract
The effectiveness of the Price Earnings Growth ratio as a valuation tool has been a topical debate amongst analysts ever since being popularised by Lynch (1989). This study examines the appropriateness of the fair value criteria of a PEG of 1,0, as proposed by Lynch (PEGL), and compares this with the time-series based, share specific model, proposed by Trombley (2008) (PEGT). In addition, the study analyses several factors which influence the accuracy of analyst’s forecasts (viz. the number of analysts’ contributions, the dispersion of forecasts and the forecast horizon), with the objective of identifying an optimal trading rule based on the PEG ratio. We find consistent outperformance of the PEGT model. We also note (unexpectedly) that analyst’s forecasting accuracy may have a less significant impact on the usefulness of the PEG ratio than their optimism. Finally, we report an optimised PEG trading rule which delivered annual abnormal returns of 13,7% over the study period. The trading rule appeared to single out small-capitalisation firms, with above market growth prospects, which performed well in a buoyant market.
Highlights
Dreman and Barry (1995) and Brown (1996) state that the primary use of analysts’ earnings forecasts is to make investment decisions, and that investors rely heavily on analysts’ views of future company performance to structure their investment portfolios
Three sub-hypotheses were tested in terms of their ability to improve the PEG based trading rule. These related to the number of analysts contributing to the consensus forecast, the dispersion between their forecasts and the forecast horizon
Conroy and Harris (1987) and Lobo (1992) both suggested that a lower dispersion in analyst’s forecasts would result in more accurate forecasts. For both the PEGL and PEGT trading rule, this study found that the portfolio with the higher dispersion in forecasts yielded greater returns than the lower dispersion in forecasts portfolio
Summary
Dreman and Barry (1995) and Brown (1996) state that the primary use of analysts’ earnings forecasts is to make investment decisions, and that investors rely heavily on analysts’ views of future company performance to structure their investment portfolios. One of the more common practices amongst investors is to use the Price Earnings (PE) ratio as a simple valuation tool to determine whether a company’s stock is over- or undervalued (Dudney, Jirasakildech & Zorn, 2008). Since PE ratios fail to incorporate future earnings growth prospects, an improved valuation metric is the PriceEarnings-to-Growth (PEG) ratio (Trombley, 2008; Easton, 2004), which is essentially a stock’s PE ratio divided by its expected earnings growth (Lynch, 1989). A recent survey of valuation practices established that 22 of 43 investment professionals use the PEG ratio as one of their valuation techniques (Trombley, 2008)
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