Avoiding Common Stumbling Blocks 229Gamble is usually afforded a fair multiple because of its decades -
long record of superior earnings visibility. Value investors attempt
to maximize value by locating those businesses that can produce
growth while paying as little as possible. The most obvious way to do
this is to buy during a period in which the company is experiencing
a temporary setback, due to general economic or specifi c industry
conditions. Doing so allows investors to pay a reduced multiple for
temporarily distressed profi ts and benefi t in the future from both
increased earnings and an increasing multiple being granted on
the security.
Expanding on the P/E ratio slightly, many investors also look
at the PEG ratio of a business. This is known as the price - earnings/
growth ratio. The PEG ratio is a valuation metric for determining
the relative trade - off between the price of a stock, the earnings gen-
erated per share, and the company ’ s expected growth.
In general, the P/E ratio tends to be higher for a company with
a higher growth rate. Thus, using just the P/E ratio would make
high - growth companies overvalued relative to others, all else equal.
It is assumed that by dividing the P/E ratio by the earnings growth
rate, the resulting ratio is better for comparing companies with dif-
ferent growth rates.
As Table 11.1 illustrates, P/E ratios alone may not be suffi cient
to determine the attractiveness of any particular investment without
a closer look at the quality and growth of future potential earnings.
If company C can indeed grow profi ts for the next several years by
20 percent, a P/E multiple of 18 may appear quite reasonable rela-
tive to the other two companies.
Consider the following basic math if these growth rates hold
for the next fi ve years and the P/Es equate to the growth rate of
the earnings. Table 11.2 makes some very rigid assumptions.
Unless a company is somehow manipulating its earnings, it ’ s highly
unlikely that it will grow its earnings by the same rate each year for
fi ve consecutive years. And depending on the prevailing marketCH011.indd 229CH011.indd 229 9/2/09 11:51:52 AM9/2/09 11:51:52 AM