Evaluating Apple’s 36x PER by the PEG ratio
Determining the stock price level with PER alone could lead to an error.
Suppose that firms A and B have the same business and that both equity capital and profits are the same for the latest fiscal year. All other factors are similar, except that firm B recently pioneered a sales channel in North America, and sales are expected to grow significantly in the future. In this case, B’s share price would naturally rise, and its PER would also increase accordingly. It is a false judgment that A’s share price is undervalued by simply comparing the two companies’ PER, excluding such a big event.
Therefore, when judging stock prices by PER, you should also consider companies’ growth rate.
Definition of the PEG ratio (PE to growth ratio)
The PEG ratio is an indicator that complements such shortcomings of PER. PEG (PE to growth ratio) is a multiple of PER divided by growth rate, which means how many times the PER is compared to its growth rate. The lower the PEG ratio, the lower the PER compared to the growth rate. So the share prices with low PEG are considered undervalued.
Determining the stock price level only with PER could lead to an error, but using the PEG ratio together could give a meaningful conclusion.
In particular, the PEG ratio could be more useful in high-growth sectors where there is a significant variation in growth rates across companies.
PEG = PER / gEPS
gEPS : EPS’ growth rate
The growth rate in the denominator of PEG is the EPS’ growth rate. Since PER is the share price divided by its EPS, the EPS’ growth rate should be used to calculate the PEG ratio.
Also, the PER time point of the PEG numerator should be the same as the growth rate time point of the PEG denominator.
When you use trailing PER for the PEG ratio, the EPS growth rate of the PEG denominator should be as of current. If you use forward PER, you might use the long-term growth rate of EPS, but not as of current.
Trailing PEG = Trailing PER / gEPSt = (PER/EPSt) / gEPSt
Forward PEG = Forward PER / gEPSlong-term = (PER/EPSt+1) / gEPSlong-term
gEPS: The long-term growth rate of EPS
The forward PER’s denominator is the estimated EPS for next year, so it already reflects at least a one-year growth rate. The EPS’ growth rate for the forward PEG ratio should reflect the growth rate for more than two years.
Like PER, the PEG ratio is useful when comparing companies in the same sector.
Some sectors have a high PEG ratio, and some sectors have a low, depending on the business nature. For example, the higher the growth rate, the higher the business risk. In this case, high-risk firms may appear to be undervalued compared to low-risk firms due to the low PEG ratio.
So, if you compare the PEG ratios across sectors with a different business risk and growth rate, you may decide a wring decision.
Case study: The PEG ratio in the US technology sector
PER and PEG ratio of the top 9 companies in the US technology sector (Source: Thompson Reuters)
The table above shows nine companies with a high market cap in the US technology sector as of February 2021. It also includes each company’s PER and forward PEG.
When seeing the PER multiple alone, Netflix is the most overvalued with its PER 93.09, and Intel is the most undervalued with 11.74. Meanwhile, the PER of Apple, which has the largest market cap, reaches 36.
The PERs of Nvidia, Netflix, and Broadcom are above the nine companies’ average PER 49.9, while the rest are lower than the average.
The forward PEG in the table above is the forward PER divided by the long-term growth rate of EPS.
The nine companies’ average PEG is 1.90, and Apple, Nvidia, Intel, Adobe, and Broadcom are above the average PEG. Microsoft, Google Alphabet, Facebook, and Netflix are below the average.
We can consider Netflix’s share price the highest according to its PER alone, but the PEG ratio is 1.22, which is relatively undervalued. Meanwhile, Intel’s PER is the lowest with 12x, but the PEG ratio is 2.25, which is higher than the average. In other words, its expected growth rate in EPS is not relatively high.
Meanwhile, Apple’s PER is about 36x, which was slightly lower among the nine companies, but the PEG ratio is a bit higher than the average.