Tuesday, March 01, 2005

Low PEG Helps But High Growth Is Even Better

How useful is low PEG as an indicator of good value and growth potential?

To answer this question, let's take a look at a few examples:

Company (Ticker): Fwd. P/E, 5-yr. Est. Growth, Fwd. PEG Ratio

Exxon Mobil (XOM): 16.8, 6.7%, 2.5
Posco (PKX): 5.3, 13.0%, 0.4
Google (GOOG): 36.4, 30.5%, 1.2
Sina (SINA): 22.2, 36.6%, 0.6

Company (Ticker): Dividend Rate, "Same P/E" Return, Implied P/E 5 Years from Now for 20% Annual Target Return

Exxon Mobil (XOM): 1.7%, 8.4%, 28.1
Posco (PKX): 4.3%, 17.3%, 6.0
Google (GOOG): ---, 30.5%, 23.9
Sina (SINA): ---, 36.6%, 11.6

The price of Exxon has recently soared with the rise in oil prices to the $50 per barrel range. However, analysts' consensus estimates indicate just 6.7% annual earnings growth over the next 5 years. If the current forward P/E of 16.8 remains unchanged, the annual return over 5 years will be 8.4%, including the 1.7% dividend rate. In order to reach a 20% annual target return with the stated growth rate, Exxon's forward P/E would need to rise to 28.1 in 5 years. This type of multiple expansion is very unlikely for a large cap commodities sector company. In this case, the PEG of 2.5 tells us that the stock price is too rich for the earnings growth capacity of the company. Oil prices may continue to rise but probably will not rise at the fast clip needed to boost Exxon's earnings enough for consistent double-digit growth over the next 5 years. Consequently, I do not expect Exxon to deliver 20% annual returns over the next 5 years.

Posco, with a forward P/E of just 5.3 and estimated earnings growth of 13.0%, will produce a 17.3% annual return (including the 4.3% dividend rate), if the forward P/E remains unchanged. With only very modest mutiple expansion to 6.0, this leading Korean steel company can produce attractive 20% returns. The low PEG of 0.4 correctly indicates the good value and growth potential here. Posco shows promise of becoming a solid investment, assuming the analysts are right with their 13% annual 5-year earnings growth projection.

Among investors (and speculators), Google is as well-known for trading at an extravagant trailing 12 months P/E of 129, as it is for being the world's premier search engine. Its forward P/E is a less lofty 36.4 and, if the company is able to deliver analysts' estimated 30.5% earnings growth, the stock will give at least a 20% annual return over the next 5 years if the forward P/E ends up at 23.9 or higher. As Google and the Internet search business matures, growth will eventually slow. However, I would guess that in 5 years' time Google's forward P/E could still be in the high 20s, making it very possible that the stock could produce 20% or higher annual returns over the next 5 years, even though its PEG is currently 1.2.

Sina, with a forward P/E of 22.2 and a very high estimated earnings growth rate of 36.6%, will give at least 20% annual returns if its forward P/E is 11.6 or higher 5 years from now. The ongoing modernization of China, as reflected in the country's GDP that has grown around 9% annually for the past decade or two, is very likely to continue to drive economic (and Internet) growth for many years to come. If Sina's forward P/E remains unchanged at 22.2, annual returns will be a very attractive 36.6%, assuming that estimated earnings growth materializes as anticipated by analysts tracking the company. This potential for high return returns is reflected in the low PEG of 0.6. (Disclosure: I am long SINA.)

To sum up:

1. Low PEG is a good indicator; however,

2. High earnings growth is really the "behind the scenes" driver of high long-term returns.

To achieve our 20% annual target returns over the long run, we really need to focus on companies that can grow earnings at a similar rate for many years to come. With oil and steel prices having shot up more than 50% last year, the higher prices will likely begin to create more supply, since it is suddenly profitable to drill a little deeper for oil and to rejuvenate rusting steel mills. When supply comes on-line to balance new demand from China and elsewhere, the recent commodity price run-up will likely cool back down to normal single-digit growth. On the other hand, with the Internet still a new technology that is drastically changing the way we communicate and live, I see high growth likely for at least the next decade.

Conclusion: Price matters, but growth matters even more.

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