29 November 2011

PEG Ratio - Concerns

PEG Ratio - A ratio with the formula PE Ratio divided by EPS Growth Percentage. The lower the ratio the better it is for investment. In traditional finance theory, if we look at low PEG ratio, it can be either the PE ratio is low or the EPS Growth Percentage is high. In either way, it consists of several risk that you cannot see from this formula:

1. High EPS Growth - If a company would like to sustain a ultra high earning growth, the company must also  need to sustain its revenue growth as well as Cash in Operation growth. Normally a growing co. will experience two stage of growth, an short term growth as well as long term growth. Short Term growth can be due to the co. is having a new range of products / services / market by having a lot of advertising campaign or promotion to its customers. So we can see that the A&P expenses will go up first before the revenue growth comes in eventually. While we cannot determine whether the revenue growth can be sustainable, we must also look at the company's Balance Sheet as well as Cash Flow Statement. A strong BS (e.g. Good Current Ratio, Liquidity Ratio, Debt-To-Equity Ratio, Positive FCF etc) indicating a company is growing within a healthy condition.

2. Low PE Ratio - Normally a Low PE Ratio indicates that the investors do not have a very good confidence level to the company's near future or because the company requires some discount (e.g. Liquidity Issues as the company outstanding shares is not liquid, or Market Cap Issues as the company market cap size is smaller). An Institutional Investor normally buy the blue chip  stock first before they look into a smaller market cap stock as they always want to reduce the execution cost (e.g. they can easily buy and sell at one shot without waiting for few days to complete one transaction).

With above concerns, we must have to study more after we filter out a group of stock that fulfill the PEG ratio

  • Whether the Company still can sustain the growth Rate in near future
  • Whether the Company maintain a strong Balance Sheet to sustain its revenue growth rate
  • Whether the Company able to cope with the business/finance difficulty when the downturn of the economy
  • Whether Company will get a re-catalyst in near future (e.g. Market Cap can grow to a bigger size after the revenue can grow for a long period etc)

Welcome to share with me your thought on it too. Have a nice day.

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