How the Market’s Most Misunderstood Number Could Destroy Your Saving

Dear Reader,

Hard to believe, but investors are still buying stock. In a down market, it gets harder. The rules change. The numbers mean different things. If you don’t adjust, your portfolio will sink, right along with the market.

I can’t go over everything, so I’m just going to focus on one major marker today - the PEG ratio. If you don’t know what it is, you should. For those of you who do know, have come to rely on it, and have gotten great results from using it, you need this heads-up more than anybody else.

PEG stands for price-to-earnings-to-growth. That’s a mouthful, so let’s break it down. It’s actually a ratio within a ratio. First, you need to figure out what the price-to-earnings (P/E) is. Once you have this number, you’re ready to calculate the overall ratio of P/E to “G.” “G” stands for annual growth.

We’ll look at P/E first. Then we’ll examine the “G” or growth part of the ratio.

P/E compares the price you pay for a stock of a company to its earnings. Value investors like to see P/Es of 10 or less. This means that it takes the company 10 years or less to earn the equivalent of what its stock is going for.

But it’s worth digging a little deeper to find out the P/E for the sector the company is in. For example, a company can have a P/E of 15 and be priced under the sector average. Or, a company could have a P/E of 9 and be priced over the sector average.

Sector average is important because it tells you what investors are typically willing to pay for companies in a particular sector.

The price investors attach to sectors varies for a number of reasons. For example, in cyclical sectors, investors aren’t willing to pay as much, so the average P/E will be on the low side. Why? Because these companies at some point are virtually guaranteed to drop. In other words, you pay not only for upside but for downside. That brings the price down.

Are you with me so far? Let’s move on.

As I said before, the “G” part of PEG is growth. It tells you how fast earnings are expected to grow over the next five years. If analysts expect earnings to grow an average of 10 percent, then “G” equals 10.

That’s simple enough, yes? Just one thing you need to keep in mind. For both (forward) P/E and the “G” part of the ratio, the earnings haven’t occurred yet. Forward P/E (there is also TTM – Trailing Twelve Months – P/E, so always know which P/E you are looking at) takes the average earnings of what analysts are projecting in the coming 12 months. “G,” or growth, comes from the annual average of what they are projecting for the next five years.

And as we all know, analysts aren’t always right.

Now let’s put it all together. If a company has a P/E of 10 and a projected growth of 10 percent a year, its PEG ratio is price-to-earnings (10) to growth (10). And 10/10 is one.

A PEG ratio of one is considered great. By comparison, let’s imagine a company with projected growth of five percent instead of 10. The PEG would be two (10/5). A PEG of two is okay at best. Why? You’re getting a decently valued company (with a P/E of 10), which is great. But you’re getting it with only mid-single digit growth, which is not so great.

Let’s look at another example of the PEG ratio equaling two. This time the P/E is 20 (which is expensive) and the projected growth is 10 percent a year. Now we’re in double-digit growth territory, but at the low end, and you’ve paid a lot for the stock. Again, not a great buy.

On the other hand, anything below a PEG ratio of 1 is fantastic. Take, for example, a company with a P/E of 10 (pretty cheap) and a projected growth of 20 percent. That’s fast growth and the price is cheap. A PEG of 0.5 would excite most investors, whether they’re into value or growth.

Except now things have changed. The old rules don’t apply. And it all has to do with how earnings are projected. We’re in a transition period. The economy has slowed dramatically. Companies can’t be expected to earn as much in a recession as they would if the economy was humming along.

Expectations for the economy are getting lower and lower with every passing week. So it should be no surprise that expectations for how much companies will earn are also sliding.

S&P 500 stocks are now expected to generate $98.25 in earnings per share this year, down from the $101.87 per share predicted at the end of last year, according to Reuters.

First-quarter earnings have been cut the most. Instead of rising at a 5.1-percent rate, they are expected to be basically flat.

Problem is, the third- and fourth-quarter earnings projections have been left more or less alone. They’re expected to be the bounce-back quarters. If the recession were to linger longer than expected, these numbers would have to be pared back just as much, if not more, as the first quarter’s numbers.

Knowing that, let’s revisit the company with the wondrous 0.5 PEG ratio (coming from a forward P/E of 10 and a projected growth of 20 percent a year). Because earnings for the next year could well end up below current projections, a P/E of 10 could easily turn into a P/E of 12. The math is straightforward. If shares cost $100 each and earnings were $10 per share, all it would take is for earnings to slip to $8.33.

And if the recession lasts into 2009 or, heaven forbid, 2010? The “G” part of the PEG ratio would have to ratchet down from 20 percent to maybe 10 percent or lower.

All of a sudden, instead of the exciting 0.5 PEG, we have a PEG of 12/10 or 1.2. Geesh. That puts a different spin on the company, doesn’t it?

Be careful. The projected stuff is all funny numbers now. I’m staying away from high growth numbers. Why pay for growth that isn’t real, even if you think you’re getting that growth for a reasonable price? It doesn’t make sense.

So, what to do?

You could lay low. Take a break from investing in individual companies until the numbers catch up to falling expectations.

Or you could do what I do. Run the company’s growth strategy through a recession scenario. And look for things that could offset falling domestic demand. Companies with strong exports, for example.

Other examples? Companies making mining or agricultural equipment might not feel the pinch of a recession, not with soft and hard commodities in the middle of a bull run. Or how about companies selling mostly to governments, like companies in the defense sector?

Their PEGs would be less suspect. But be careful. A company increasing exports by 10 percent and losing domestic customers at a 10-percent clip isn’t growing (unless its exports are bigger than its domestic business).

A recession is a tough environment. But investors who only like to invest long have options. Strong PEGs are now something of a trap. But if you follow my advice, you don’t have to get caught.