While using the PE Model to value shares is both easy and intuitive, there are a number of flaws with it. The most notable of these flaws is that many people value a share’s PE to an index or competitor’s PE. While this is useful for relative valuations and seeking relative value, the fact that the index and/or competitor and/or market might be over-valued is never taken into account.
For example, if you were valuing a resource company a year or two ago and had used the JSE Resource Index’s PE as a yardstick…you would not have taken into account that commodity prices were at an all time high and confidence in resource companies was over-rated.
So, using this inflated PE, you would’ve valued the resource share relatively…but not absolutely. Mainly because of this major flaw inherent in the PE Model, I am moving strongly towards using a PEG-implied PE for use in the PE Model.
To use PEG Theory to imply a “natural” PE ratio use the following simple steps:
1.) Calculate the (extremely) long-term growth rate of the company. A good company should have a long-term growth rate in excess of inflation.
2.) Estimate the risk premium on this growth rate, the riskier the company the higher the premium should be. Most JSE-listed companies tend to have a risk premium ranging from 20% to 50% on their long-term growth rate prospects due to the systematic risk of operating in a developing economy.
3.) Use the following formulate (based on the rearrangement of the PEG formula) to estimate the “natural” PE ratio:
1 / (long-term growth rate x (100% – risk premium) = PEG implied PE ratio
As the risk premium is a fairly subjective assumption in the model, I suggest that a range of risk premiums is used in order to get a better feel for the fair value range of the share.
The beauty of this approach to generating an PE ratio is that it ignores external bubbles and focuses almost exclusively on internal factors.
Keith McLachlan is a dedicated small cap investor and writes regularly for http://www.smallcaps.co.za