The Business of Value Investing.pdf

230 The Business of Value Investing

environment, the P/E ratio afforded to individual securities may

refl ect undervaluation, fair valuation, or overvaluation. There is

no accepted rule in the market that suggests that a company ’ s P/E

ratio will equal or approximate the annual growth of earnings.

Nonetheless, the table is useful in illustrating once again the

value of growth in any particular investment and, more specifi cally,

the importance of paying a reasonable price for that growth. As

you can see, there is no “ exact ” reasonable price, but what inves-

tors want to avoid is paying excessively for that growth. Both the

P/E and PEG ratios help establish the parameters between excessive

and reasonable. For company C, even if market multiples decline

and the market assigns a P/E of 12 but 2013 earnings still came in

at $ 2.48, the capital gain is still in excess of 50 percent. Conversely

if the earnings growth stalled and earnings came in at $ 2 per share

and the market assigned company C a 10 times earnings multiple,

Table 11.1 Examining the PEG Ratio

Company A Company B Company C

P/E ratio 10 15 18

Earnings growth rate 10% 10% 20%

PEG ratio 1 1.5 0.9

Table 11.2 Value of Growth

Company A^ Company B Company C

2008 earnings per share (EPS) $ 1 $ 1 $ 1

2008 share price $ 10 $^15 $ 18

2013 EPS $ 1.61 $ 1.61 $ 2.48

2013 share price (assuming same

P/E as growth rate)

$ 16.10 $ 16.10 $ 49.60

Return on investment 61% 7.3% 175%

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