Gavekal Capital: Another Valuation Metric, Another Sign Of An Overvalued Market

Monday, November 10, 2014

Another Valuation Metric, Another Sign Of An Overvalued Market

We focus a lot of our time on stock valuation because we believe that valuations are one of the best long-term indicators for future returns. When valuations are high, future returns tend to be lower and when valuations are low, future returns tend to be higher. We focus primarily on "the oldies but goodies" such as our favorite price to cash flow but also price to sales, price to book, price to earnings and enterprise value to EBITDA.  Today, we are going change it up a bit and talk about the PEG ratio and look at the market through the lens of this metric. The PEG ratio (price to earnings ratio divided by growth rate) attempts to place valuations in context with growth rates (either expected or historical). As with all metrics, the PEG ratio has several pros and cons. One of the major cons in our opinion is the use of forward-looking growth projections that are usually overly optimistic and thus, drives down the PEG ratio (which as a value investor is what you want if you are using the PEG ratio). We use long-term least squares growth rates for our "G" in this equation. Lastly, the general guideline is investors should buy a stock when the PEG ratio is below 1.

Using that as our cutoff, we wanted to see how many stocks currently have a PEG ratio of less than one. Not surprisingly, the vast majority of stocks are trading above the 1 threshold. In fact, using 3-year growth rates only 22.4% of stocks have a PEG ratio of less than one. Using 5-year growth rates only 19.7% of stocks have a PEG ratio of less than one and using 10-year growth rates only 10.4% have a PEG ratio of less than one*.

*Data note - we are excluding companies with a history of less than 3-years, 5-years, or 10-years depending on the time period quoted and where calculating long-term growth using least-squares is not possible due to sign changes. 

The average stock in the MSCI World Index has a 3-year PEG ratio of 2.4, a 5-year PEG ratio of 2.6 and a 10-year PEG ratio of 3.2. Using conventional accounting standards that don't properly account for intangible capital, the health care sector has the highest PEG ratio and telecommunications services has the lowest when 3-year growth rates are applied. However, after adjusting the financial statements for intangible capital, utilities have the highest PEG ratio followed by telecommunication services and health care drops to the fourth highest.

Using as-reported accounting numbers

Using intangible-adjusted accounting numbers