Peter Lynch ratios (PEP and PEG) and their applications in ETFs valuation

The holy grail of stock investing is buying big companies at a low price. Peter Lynch implemented a variation of this strategy in the 1980s using what is known as the Price/Earnings/Growth (PEG) ratio. It compares the valuation of companies, as measured by their price-earnings ratio, to expected growth to find stocks that offer the highest growth for the lowest price.

It’s harder to find overlooked stocks than it was in Lynch’s time because more people are looking for them – anyone with a smartphone has free access to vast markets and financial information. The result of greater competition is evident in the numbers: the fast-growing or highly profitable companies are almost always the most expensive, while the cheapest ones have weak growth or weak profits.

There is an investment case for both groups – buying cheap stocks has historically been a profitable strategy, as has buying shares of highly profitable companies. However, differences in valuation and profitability make funds difficult to compare. One way to solve this is with a variation of the PEG ratio that replaces profitability with growth, called PEP. This PEP ratio (compares the Price/Earnings ratio of funds to their yields), compares the P/E ratio of funds to their yields, and like the PEG ratio, the lower the PEP ratio, the better.

For example, based on analysts’ earnings estimates for the next 12 months, the tech-dominated Nasdaq 100 Index has a P/E ratio of 27 and a return on equity of 21%, yielding a PEP ratio of 1.3. By the same measure, the S&P 500 index and the MSCI ACWI ex USA index, which represents the global stock market excluding the US, have PEP ratios of 1.1 and 1.2. Of the three, the Nasdaq 100 offers the lowest share price yield.

Of course, this is not always the case because markets are constantly reassessing various factors. For most of the time since the 2008 financial crisis. The Nasdaq 100 had a lower PEP ratio than the S&P 500 and ACWI ex USA, a leadership from which has changed recently.

But these are not the only three choices. The highest PEP ratio goes to U.S. small-cap growth stocks, for which investors pay 44 times forward earnings for a 2.5% return on equity, resulting in a terrible PEP ratio of over 17. The best bang for the buck belongs to high quality emerging market stocks, which deliver 16 times earnings in return for a 23% return on equity or a PEP ratio of just 0.7.

There is insufficient historical data for all stock asset classes to say anything empirical about the PEP ratio, but the available evidence around individual stocks suggests that low price and high yield are a powerful combination. In the U.S., stocks of the cheapest and most profitable companies have historically performed the best, outperforming the most expensive and least profitable companies by 9 percentage points per year over the past 60 years, including dividends.

 Dealer Anatoliy Pavlov

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