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Mathew Ingram

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New tool in the shed

Mathew Ingram

TORONTO (GlobeinvestorGOLD)—After reading through various brokerage research reports and trying to perform surgery on the shattered remains of your stock portfolio, you find your head swirling with industry jargon: price-to-earnings ratios, free cash flow, enterprise value, EBITDA. Your fevered brain is filled with questions, including: Am I back in calculus class? And how exactly are you supposed to pronounce EBITDA anyway?

At the risk of contributing to that terminology overload, the usual roster of stock valuation tools such as price-to-earnings and price-to-sales could use a little updating. In many ways, they are the equivalent of a ball-peen hammer or slot-head screwdriver: useful, but not up to some of the more complicated jobs.

One of the newer tools out there is the PEG ratio, which stands for "price to earnings growth." Although it does have its weaknesses, some of which became abundantly clear during the stock market bubble of the late 1990s, if properly used it can be a useful filter when trying to decide which stocks are undervalued and which aren't. It can't do everything, of course, but it belongs in the toolbox just the same.

In many ways, the venerable P/E ratio is a blunt instrument. All it tells you is that one stock is selling for 10 times its earnings per share, and another is selling for 30 times earnings. And yet the two companies could be in completely different industries, and could also be at completely different stages of development. Should they be valued in the same way? Most analysts would argue that they shouldn't.

You can compare the P/E of each stock to the average multiple in their respective industries, and in fact you should, since that might help give you a sense of their relative value. But you may still be dealing with two very different companies at completely different stages of evolution, and a one-size-fits-all P/E ratio comparison isn't going to help that much. That's where the PEG comes in.

Same thing, only different

Just because one of your stocks is selling for 30 times earnings and another is selling for 10 times, that doesn't necessarily mean the latter is three times more undervalued. If the company in question is in a low-profit, long-established industry, such as CP Ships, with growth in the 10 per cent range, then 10 times earnings is arguably fair value. If the other company happens to be growing at 30 per cent per year, as WestJet Airlines is, then it might also be close to fair value.

In a way, the idea of the PEG ratio is to compare the earnings of a company to itself, that is, to compare the P/E of a stock to the company's internal growth rate, with fair value in the range of a one-to-one ratio. In other words, if a particular company can only manage to increase its earnings at 10 per cent per year, then its stock is arguably only worth 10 times earnings; if a company can produce growth of closer to 30 per cent per year, then its shares arguably deserve to trade at close to 30 times earnings.

There are risks associated with the PEG ratio, of course, as there are with any other valuation method. As with the P/E ratio, the most dependable view is backwards, looking at a company's past earnings growth. However, since investors are intent on the future, there is a tendency to use the anticipated rate of growth, rather than the actual rate. The risk is that the anticipated rate may be based on some pretty grand assumptions about a company's potential, as it was for many during the dot-com bubble.

Wishful thinking

3-year performance of Nortel's stock on the TSXWhen Nortel Networks was increasing its earnings at 30 or 40 per cent per quarter, for instance, many analysts made the case that the shares should be valued at 30 or 40 times earnings, plus a little extra because it was an industry leader. That's how many of them justified the fact that Nortel was selling at an incredibly high multiple. Nortel's growth couldn't be maintained at that pace for long, however, since it depended on telecom companies increasing their capital spending at 30 or 40 per cent per quarter.

Using Nortel as an example (and there are plenty of others) brings out another risk in the PEG ratio, as well as the P/E, and that is they both depend on how you define earnings. As we know from countless examples over the past few years, companies and analysts often have a number of different ways of defining "earnings." Read Fabrice Taylor's story on understanding earnings.

Nortel, like many companies, used "pro forma" earnings, which are profits with various extraordinary charges, writedowns and other expenses arbitrarily removed. Using pro forma earnings can make a company's profit seem larger, which in turn makes the stock price look a lot less expensive.

These risks aside, however, the PEG ratio is another useful tool for an investor to have, like the instruments lined up as the surgeon prepares to operate. As you try to revive your ailing portfolio, you need all the help you can get.

Mathew Ingram joined The Globe and Mail's online news team in June of 2000, after spending four years as the Western business columnist, based in Calgary.

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