Back to Drew's Views
December 10, 2019
Previous
Next

Pegs, P/E'S and the Value Premium

Asset Pricing
Valuation

Several years ago, we did an analysis of companies starting with a specific starting growth rate, and assumed that they would do a straight-line ten-year fade to a growth rate equalling inflation.  

We treated all the earnings as if they were free cash flows, assumed 100% equity financing, and then determined a value for each theoretical security.  We then divided that model stock price by the current earnings to arrive at a “proper P/E ratio”. We also sensitized on discount rates just to see what the impact might be on that “proper P/E ratio”.

The next stop was calculating the PEG ratio.  At the time, the PEG was a very popular metric (it was during the internet bubble) and most stock-pickers had a lot of trouble understanding the right “level”.  The chart to the right shows why.

Basically, the notion that the PEG is a linear tool for valuation is a myth, and a PEG greater or less than a certain level (say of 1.0) isn’t necessarily expensive or cheap. The convexity of the PEG relationship impacts the “fair” value, as the second derivative of the PEG line is always positive.

While it seems counterintuitive at first blush (that very slow growers should have high PEGs), it actually makes perfect sense after thinking about it.   As the denominator in the PEG ratio becomes so small, companies with almost no growth are still worth something, and have nearly infinite “proper” PEG ratios.  Then, as you move from 0% growth to the right, the proper PEG ratio drops and appears to bottom somewhere between 20%-30% EPS growth as a starting point.

As mentioned, this analysis was done during the tech bubble, and there were plenty of names that were benefitting from the convexity of the relationship.  If we cut off those abnormally high growth names, we got a picture that looked more like this one.

‍

And there is another interesting phenomenon when looking at the “proper P/E ratio” in different regimes of interest rates.  Basically, the lower the interest rate, the greater the difference in fair valuation between “value” stocks (the supposed low-growers) and “growth” stocks.

Essentially, the difference in outperformance of growth stocks over value stocks accelerates as interest rates drop toward zero.

This mathematical fact may help to explain some or all of the consistent underperformance of the value factor over the last several years.

‍

FOOTNOTES

Download PDF

Topics

Asset Pricing
Valuation

DISCLAIMER

The views and opinions expressed in this post are those of the post’s author and do not necessarily reflect the views of Albert Bridge Capital, or its affiliates. This post has been provided solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The author makes no representations as to the accuracy or completeness of any information in this post or found by following any link in this post.

YOU MIGHT ALSO LIKE

Text Link

Heading

Lorem ipsum dolor sit amet, consectetur adipiscing elit. Suspendisse varius enim in eros elementum tristique. Duis cursus, mi quis viverra ornare, eros dolor interdum nulla, ut commodo diam libero vitae erat. Aenean faucibus nibh et justo cursus id rutrum lorem imperdiet. Nunc ut sem vitae risus tristique posuere.

Text Link
Text Link

Sell in May and Go Away?

Turns out there may actually be something to the old Sell in May and Go Away adage - at least over the last 80+ years.

Markets
Asset Pricing
Read More
Text Link

The Politics of Passive Investing

Most of us in the finance world are well aware of the evolution of “passive” equity investing over the years, and have witnessed its tremendous growth. Some of us have asked questions about it. We’ve asked is it all good? Is it mostly good? Are some aspects perhaps bad? Are some really bad?

Asset Pricing
Passive vs Active
Read More
Text Link

Stock Market History, Illuminated

Some year-end charts and tables asking some big questions about what comes next.

Asset Pricing
Factors
Markets
Valuation
Read More
Text Link

Do Short Term Flows Permanently Affect Share Prices?

I’d like to think that prices can get out of whack for some period of time, and in that window, the nimble, unbiased, fundamental stock picker can take advantage of overreactions and underreactions. If they don't, then the M&M propositions truly hold, and I don’t have a meaningful job. However, if this paper is right, and it is only flows that matter, then while the M&M theorems are overturned, I don't have a meaningful job either. If it is all about flows, then I shouldn't play the game.

Asset Pricing
Behavioural Finance
Passive vs Active
Valuation
Read More
Text Link

Just How Cheap is Europe vs. the US, and Should it Be?

As it turns out, it isn’t that the people are paying a bigger growth premium for US Growth over European Growth; but instead it is that people are paying a (much) bigger multiple for US Value than for European Value.

Markets
Stock Picking
Valuation
Read More
Text Link

Rumpelstiltskin and Meme Stock Investing

“What sort of sorcery is this?” Is this financial alchemy powering a perpetual motion engine that will result in higher and higher share prices?

Markets
Stock Picking
Valuation
Read More
Navigations
HomeTeamDrew's viewsPressContact
Disclaimers
Legal & regulatoryPrivacy policyCookies policy
How to get in Touch
info@albertbridgecapital.com

Subscribe to Drew's Views

No spam. Unsubscribe anytime.
Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.
© Albert Bridge Capital 2022
Website by SW10media.com
On the Relationship Between Gasoline Prices and Vehicle Demand
Sell in May and Go Away?
The Politics of Passive Investing
If Growth Stocks Sell Off Will They Bring Value Stocks Down with Them?
Stock Market History, Illuminated
Which One Are You?
Was Ben Graham a Quant?
Do Short Term Flows Permanently Affect Share Prices?
Just How Cheap is Europe vs. the US, and Should it Be?
Are American Companies Better than European Ones?
Rumpelstiltskin and Meme Stock Investing
Archegos, Disclosure, and Price Discovery
It's All About the Fundies
On Unlimited Upside
A Memo to Investors
Investors? Possibly you!
Avengers Assemble!
How Did This Even Happen?
Was “Value” Just a Hot Hand Thing?
The Hot-Hand Fallacy Fallacy Fallacy?
Cue the Camouflage
The Times that Try Stock-Pickers’ Souls
A Different Game?
Heads I Win
A New Ice Age?
Grandpa Stocks
Bubblicious?
On Negative Oil and Futures Prices
In Flew Enza
COVID-19 and Equity Markets
Regulators to the Rescue?
Perspective
We Don’t Make Pizzas
Ben Graham the Growth Investor?
Not a Bad Decade
On the Impact of the FAMANGs
Europe vs the US: Is it all about sector exposures?
Behavioural Finance is Finance
America’s Decade
Known Unknowns and Share Prices
Prediction, Publicity, and Paul the Octopus
Are Company Visits Good or Bad?
Everybody Was Kung Fu Fighting?
Voting Machines and Weighing Machines
The DCF is the Randy Watson of Valuation
The Sacrilegious Diaries: Measuring the Impact of Portfolio Turnover
Passively Irrational?
Imagine No Inflation
The Sacrilegious Diaries: The Benefits of Turnover
Stay in the Game
I’m Volatility?
Woody was Right
When You Can’t Wait For Tomorrow
James Harden and Alpha
Groundhog Day and Overnight Returns
Debiasing and Alpha
Peak “Peak Car” ?
The Right Way
The First Step to Regaining Credibility
The Futility of Market Timing
Visualizing the Arithmetic of Active Management
123 Years of the Dow
Sweet Emotion?
Share Buybacks, Bad Companies, and Bear Markets
Risk and Portfolio Theory
Keeping Calm and Carrying On
Reminiscences of a Stock Operator: The Volkswagen Chronicles, Ten Years Later
We’d Rather Not Sleep
Factor Timing, Should You Try?
The Mathematics of Maintaining Bet Size
The Grandfather of Behavioural Investing
On Sexual Chocolate and Semi-Annual Reporting
Island Economies and Risk
Build a Bear?
Data Science and Alpha
We’re all Value Investors
Hunting for Alpha
Career Risk, Alpha, and Contrarian Investing
Passive Flows and Wheelbarrows
God Bless the Shorts
Equilibrium Happens
Horses and Stocks
Peak Quality?
Bill Sharpe and Hank Aaron
Unwarrented
The Search for Excellence and the Loser’s Game
Fooled by Non-Randomness
Half Hearted Is Half Minded
Still Superman, but without the cape
122 year Dow Jones Histogram: Putting 2017 into context
Pegs, P/E'S and the Value Premium
Rick Barry and Lewis Carroll
Secular Winners and Value Investing
On Passive Flows, Smart Money, and Alpha
The Voting Machine
Prevous
Next
homeTeamdrew's viewspressCOntactDisclaimers