What could be even more predictive than the PE Ratio? The five-year Forward PEG Ratio. This takes the Forward PE we just learned about, and divides it by the 5-year expected growth of the earnings of the company. G stands for growth.
For example, remember that Amazon had a PE of 15. But how does that compare to XYZ utility company with a PE of only 12? XYZ would be a better buy, right? Not necessarily.
A quick story on how these funds came about. I had never even had the thought of creating my own funds. Then one morning I woke up and my head was completely full of formulas, graphs, methodologies, marketing, and rates of return. It was so full, it literally took over an hour for me to explain all of it to my wife that morning.
While she is not a financial professional she is pretty sharp and well-educated. Although she has wisely discouraged some of my business ideas, I’m grateful that she encouraged me to pursue the project of bringing a new fund to market that would use the PEG ratio.
As I researched what would be involved, I was told over and over by industry analysts that I didn’t have enough money, contacts, or clout to even consider a successful launch. They proclaimed the project dead on arrival.
Not so! We launched a fund in June of 2011 on the New York Stock Exchange. In honor of the fund’s launching, I was given the privilege of ringing the opening bell on the NYSE.
Assume that Amazon was projected to grow their earnings by 15% per year over the next five years. Also assume XYZ had a 6% growth of earnings projected. Amazon would have a PEG of 1.00 and XYZ a PEG of 1.50. Lower is better, so even though both companies look good, Amazon looks better. What the PEG is telling me here is for every $100 I invest into Amazon stock, my expected share of company earnings over just the next 5 years should be about $60. This amount calculates to about $50 for XYZ.
How strongly do I feel that the PEG Ratio is the single most important and all-encompassing analytical tool in stock market valuation? Along with some very talented employees and the people at AdvisorShares, we were able to spearhead the effort to bring this solution to the public in the form of a Domestic-based Fund and an Internationally-based Fund.