PE-based valuation of companies: A five-minute strategy

The table below shows the simulation-based fair value of the price-to-earnings (PE) and price-to-earnings-to-growth (PEG) ratios associated with various annual earnings growth rates. It uses an approach discussed in this blog (). The lowest growth rate shown is minus 50 percent, which would refer to a company whose net profits are going down by 50 percent every year. The highest growth rate shown is 100 percent, for a company whose net profits are doubling every year.

Generally speaking, a PE of 12 is considered indicative of fair value, and so is a PEG of 1. As you can see, these are gross simplifications that would apply only to a company whose annual earnings growth rate is about 10 percent. By contrast, a company whose earnings are contracting at a 2 percent annual rate would be fairly valued with a PE of 6.51 and a PEG of -3.25. At the other end of the growth rate scale, a company whose earnings are growing at an annual 75 percent rate would be fairly valued with a PE of 260.47 and a PEG of 3.47.

As we can see, the relationship between the PE and PEG ratios is nonlinear. This is why valuations sometimes look odd to those thinking in terms of a PE of 12 and a PEG of 1. High growth companies, often in cutting-edge technology areas, may be fairly valued at PEs that look astronomical and PEGs that are significantly greater than 1. The video linked below discusses this in a bit more detail.