A big problem for value investors using ratios to evaluate stocks is incorporating growth into the evaluation. Without growth, a stock likely won’t revert to the mean and will probably stay at lower valuations forever (or until it dies).
One brilliant way to incorporate growth into value ratios is with the PEG ratio, popularized by Peter Lynch.
I want to take that one step further. Call it, the Safety 1st PEG.
The Safety 1st PEG Ratio
The PEG ratio stands for Price-to-Earnings-to-Growth, and it’s traditionally been calculated as the following:
PEG = (Price / Earnings) / Growth
Why it can be so effective is because it removes that terrible business aspect away from a dirt cheap P/E.
In order for a company to have a low PEG, it needs to have enough growth even if the P/E is low. And it also allows wiggle room for higher growth companies to command a slightly higher P/E.
This works great for a long term, margin of safety approach.
But you can’t just plug in numbers and call it a day. We need that margin of safety, emphasis on the safety, which is where a Safety 1st PEG can come in.
The Safety 1st PEG takes the PEG and just says, instead of blindly assuming that a company will grow like it did last year, why not take a margin of safety to that growth estimate.
You can do this by taking a median of 3 years of growth instead of one, like I included as an option for the VTI v7.2 spreadsheet, or you can do it intelligently by looking forward instead of backwards.
In the business world, unfortunately, the rear-view mirror is always clearer than the windshield.–Warren Buffett
In other words, we’re going to assume that a company can match or slightly do better than the economy, while keeping reasonable expectations on its future growth.
I did some research on the average EPS growth rates for companies in the S&P 500 over the last two decades, and I highly recommend you check it out (link to be published here soon!).
To summarize, here were the percentages of growth rates for these companies:
- Probability of S&P 500 company averaging 10%+ growth = 30%
- Probability of S&P 500 company averaging 15%+ growth = 13%
- Probability of S&P 500 company averaging 20%+ growth = 5%
Keep in mind that companies in the S&P 500 are among the best in the world, and even among this group there’s a very small fraction of them who grow at 15% or 20% per year consistently.
So, a good Safety 1st PEG ratio would keep the realities of long term growth in mind, and not blindly plug in growth rates of 15% or 20%+ unless there’s a very good reason to do so.
What’s a Good Safety 1st PEG Ratio?
The regular PEG ratio logic of thinking says that a PEG below 1 is very good. But if we were to take the long term P/E average of the stock market, P/E = 15, that means we’d have to have a growth rate of 15%+ in order for that PEG to look attractive.
Sure, a company can maintain 15%+ growth for a year or two, but is that reasonable to expect for the long term?
I think not! Remember, emphasis on the safety!
So a Safety 1st PEG doesn’t require a PEG of below 1 but rather says that any Safety 1st PEG less than 2.5-to-3 is likely to be a great indicator of good returns moving forward.
If you run the numbers, which I won’t do here, you’ll find that a Safety 1st PEG below 2.5-to-3 allows for some mean reversion to happen on higher P/E stocks over the long term while still maintaining attractive investment returns.
Basically, at a certain point the higher growth makes up for the shrinking P/E over time, which is captured by that guideline.
Remember that a Safety 1st PEG relies on making a reasonable growth rate estimate for a company instead of blindly taking the most recent results and projecting that growth far into the future.
That, along with the growth component added, separates it from every other price-based metric out there and is a great way to apply a long term margin of safety concept to finding solid buy and hold candidates.