The implications for a negative PEG ratio might not be as bad as you think. It all depends on the reason behind the negative PEG ratio, which breaks into 2 possibilities. One spells trouble while the other might not.

I’m writing this post as a response to an email I received from a reader. He had seen the post I wrote last week about negative P/E ratio, and simply wondered, “what about negative peg ratio”?

If you haven’t read the post about negative P/E yet, I suggest doing that first. You’ll see that it potentially plays a factor into a negative PEG ratio, and you should understand all the reasons why I strongly warn against a negative P/E.

Before digging into the PEG scenarios we first must know how to calculate PEG ratio. It’s a simple division, dividing the P/E ratio by the earnings growth. Now in most general stock market websites, they use yearly earnings growth to calculate PEG. However, some may use Q/Q growth instead, so it’s important to check the numbers for yourself before trusting any website’s ratio.

PEG = (P/E ratio) / (Growth in Net Earnings)

I covered how to calculate P/E ratio in the previous blog post. The upfront calculation for growth, for those who are still unclear, would be this year’s earnings minus last year’s earnings divided by last year’s earnings. Or, if this year was 2015 and last year was 2014…

Growth in Net Earnings =
(2015 Net Earnings – 2014 Net Earnings) / (2014 Net Earnings)

The PEG ratio works like the P/E ratio, in the sense that a lower value is generally more desired. Whereas a P/E ratio is showing how much you are paying in relation to earnings, the PEG ratio expresses how much you are paying in relation to the growth. You can think of a PEG less than 1 as meaning that you are getting more growth than you are paying for, and a PEG greater than 1 as getting less growth than what you are paying for.

This assumption is loosely accurate and wildly based on Peter Lynch’s growth strategy where he wants a growth rate at least higher than the P/E ratio. A stock priced at 17 times earnings is expected to grow 17% next year, which is how this idea is derived. Of course, the way that things play out in the real world and how conventional wisdom tells you they should play out are rarely the same. But still, this is a mostly accurate calculation that I can endorse.

Looking back at the formula for PEG, we see there are only 2 possibilities.
1. P/E ratio is negative
2. Growth is negative

If the PEG ratio is negative because of a negative P/E ratio, the same logic applies as I shared earlier. This is a situation to avoid at all costs, because negative earnings are an extremely risky place for a business to be in. The possible gains that could be made by gambling on a comeback story aren’t enough to justify the enormous risk you take by investing in this kind of situation.

The 2nd situation isn’t as black and white. If a company’s growth is negative, it could be something you want to avoid. But, companies lose growth every once in a while, especially temporarily. Even the greatest stocks that have compounded early investor money many times over have fell subject to negative growth from time to time. I mean, just look at the way the economy functions.

During a depression or recession, businesses just naturally compress even if they are strong leaders of their industry. The impact of economic hardship frequently affects the whole stock market in a butterfly type effect, and so the health of earnings naturally deteriorate during those times. It’s the scale at which earnings deteriorate that prudent investors need to monitor. If a company gets hit so hard that earnings go negative for the year, thus creating a negative P/E ratio, then again this must be absolutely avoided.

So how can you determine the worth of a company if their growth is recently negative?

It’s for this reason that I implement the average 3 year growth rate in my Value Trap Indicator calculations. Whenever I look at a stock, I’ll look at its current one-year earnings but I’ll also look at its 3 year average growth. This allows me to smooth over any temporary variations and get a more complete picture on whether the business is growing strongly.

# Negative PEG Ratio Conclusion

So my answer on a negative PEG ratio based on negative growth? It depends.

If the 3 year average growth is still strong or if the company’s valuations and balance sheet are so attractive that short term under performance can be tolerated, then I’ll consider still buying the stock. I’ll admit it takes practice to make the distinction I’m referring to, so beginners might want to beware. But to think that a negative PEG ratio should automatically disqualify a stock is nonsense.

One last thing you should consider is that a company with negative earnings will have wacky PEG calculations. Not only will the numerator be negative with a negative P/E ratio, but the growth will be impossible to calculate. Try to calculate growth with one year in the negative, or even two years. It’s impossible because the growth isn’t real, and it’s for this reason that you shouldn’t bother with calculating PEG ratio if a company has negative earnings.

The negative sign throws off the calculations, and either overstates or understates what growth would’ve been. Plus, a company that’s losing money and then “grows” to lose less money is still losing money. A company like that is in a precarious state and should be avoided like the plague.

**Negative PEG Ratio Implications**