The Fallacy of the PEG Ratio

“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t… pays it.” -Albert Einstein

Here’s a thought experiment – would you rather pay 10x for a business which will grow at 10% over 10 years (business A) or 20x for a business which will grow 20% over the same time period (business B)?  Some value investors would overlook the 20x business because it wouldn’t pass traditional value screens.  Or, investors would see the two opportunities as equivalents given a similar PEG ratio of 1.0x.  Let’s see how the math actually works.

Let’s say each company earns $1.00 today and both will trade in the market at 10x earnings 10 years from now.  This implies a 50% compression in the trading multiple for business B.  At the end of 10 years, business A will earn $2.59 and business B will earn $6.19.  The compounded returns of an investment in business A will be 10%.  Business B, by contrast, will earn a compounded return of 12%.  What’s incredible is business B will earn a higher compounded return despite a 50% compression in the exit multiple.

There aren’t very many businesses which can compound earnings at 20% for greater than a decade.  Wal-Mart was one company which did so.  Yet, you couldn’t purchase Wal-Mart for less than 20x earnings for most of the company’s trading history.  Despite this seemingly expensive price, Wal-Mart was one of the great buys for 20+ years.  Buffett commented in the past that he forfeited billions on Wal-Mart because he knew enough to make a purchase, but sat on his thumb because the price kept moving up.

Munger understood the power of compounding early on and unlike Buffett, was willing to pay up for the great companies. Given enough time, a seemingly expensive price is neutralized by the earnings power of the business.  Let’s look at Google.  Google went public in 2004 at a $40 billion valuation and 40x earnings multiple.  Today, Google earns nearly $15 billion.  If you buy a business for 2-3x 10 year forward earnings, you will become extremely wealthy over time.  Google has returned greater than 10x for investors over the past decade, a 30%+ compounded return.

The power of compounding, although simple in concept, is difficult to internalize.  We should always think about what the earnings power of the business could be 10 years from now and determine whether what we’re paying today is cheap / expensive in relation to those earnings.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s