In part one, we looked at the price to earnings, or PE ratio. In this second part looking at the basics of useful tools for investors we explain the PEG ratio, and briefly discuss how investors might spot value hidden on a company’s balance sheet.
THE PEG RATIO
The PEG ratio acronym stands for price to earnings growth, a measure popularised by successful investor Jim Slater in the 1980s and 1990s. The PEG effectively measures the relationship between a share's price top earnings (PE) ratio and the pace of its forecast earnings growth rate.
The faster a company's expected earnings growth, the faster its PE will fall.
To calculate PEG, simply divide the PE by the stock's EPS growth rate.
HOW THE RATINGS WORK
A PEG rating of between 0-1 makes the shares current value relatively cheap compared to its expected earnings per share (EPS) growth. This implies that the shares may be due an upwards re-rating on the basis that the wider market has yet to reflect faster earnings growth in the stock price.
PEGs substantially higher than 1 would suggest that, earnings growth is being fully reflected in a stock’s valuation. A PEG of less than zero - a negative metric - most likely tells you either that a company is loss-making (therefore it has not earnings) or that its earnings are declining.
In either case, a negative PEG is not a useful valuation measure and should be ignored.
BOOK VALUE - A TAKEOVER GUIDE?
At the simplest level, a company is worth the value of its assets minus its liabilities, or its book value. Book value is the amount of money that would be available to shareholders if the company's assets (excluding intangibles such as copyrights, patents, brands and other intellectual property, were sold at their balance sheet value and all liabilities were paid.
For example, if assets equal £100 million, while liabilities are £60 million, then the company's book value is £40 million.
Book value is often expressed in per share terms, or book value divided by the number of shares in issue. The market price per share is then compared to the book value per share, a figure called price-to-book value ratio.
It is worked out by dividing the share price by the book value per share.
This can be a handy, if sometimes simplistic, way to identify potential takeover targets. If the market value of a company, or its share price, is lower than its book value, or book value per share then, in theory, a buyer could take control, and sell the company's assets for more than it paid.
This was a key theme during the heyday of the asset-strippers in 1970s and 1980s.
Alternatively, a new management team may provide fresh ideas of how to crystalise the underlying value of a business with a low market value versus its balance sheet assets.
HIDDEN VALUE
A major drawback with book value is that it can be difficult to value assets accurately. It may be unrealistic to assume that the value of a tangible company asset on the balance sheet equals the value it would fetch if it were to be sold off.
This is especially true when you're dealing with intangible assets, such as patents and brands.
This problem is compounded by the fact that in recent times a far higher value has been placed on intangible assets than in the past.
On the other hand, it may be that assets on a company’s balance sheet are not being valued highly enough. For example, perhaps a company’s industry reputation is worth more than indicated.
This has been particularly true of property assets in recent decades because of soaring property valuations. That factory out in Didcot, say, may be worth far more to a housebuilder which could flatten the facility and build a load of commuter-belt homes on it.
