An Investigation into the
relationship between
the PEG Ratio and
the Capitalization Rate
By
Gaylen Bunker
Peter Lynch quote
“The p/e ratio of any company that’s fairly
priced will equal its growth rate”
“One Up On Wall Street,” Lynch & Rothchild, Simon and Schuster,
New York, 1989, page 198
“Earnings multiples or capitalization
factors are simply the reciprocal of cap
rates. A 20% cap rate is the same as an
earnings multiple of five times. In the
above example, capitalizing the
$100,000 earnings at 20% is the same
as valuing the business at five times
earnings.”
The CPA Journal
http://www.nysscpa.org/cpajournal/old/16373958.htm
Typical Capitalization Rate Sources
1. Market (1÷ P/E ratio) = cap rate
This cap rate incorporates TOTAL market
expectations regarding future growth, future
value, holding period, etc.... In theory, it is the
best available method of estimating market value
since it relates value to earnings…using market
derived data.
2. Discount Rate - estimated growth rate = cap rate
http://www.bus.ucf.edu/weaver/BV%20&%20Litigation%20Support%20Ar
ticles/articles/businessvaluationtechniques.htm
Lynch’s equality
• For PEG: P / e = g
(Lynch equality)
• 1 / (P / e) = e / P = 1 / g
e / P = Capitalization Rate
• (k - g) = Capitalization Rate
• k-g=e/P=1/g
Lynch’s equality
• For PEG: 24 / 2 = 12%
(Lynch’s Equality)
• 1 / (24 / 2) = 2 / 24 or .0833
2 / 24 = Capitalization Rate
• (k – g) = .0833 = (.2033 - .12)
• (.2033 - .12) = 2 / 24 = 1 / 12
PEG CapRates/Growth
Growth
.05
.10
.15
.20
.25
.30
.35
.40
1/g
.2000
.1000
.0667
.0500
.0400
.0333
.0286
.0250
PEG line and Market line (interest rate change)
Capitalization Rate to Growth
Capitalization Rate
0.25
0.20
y = 0.01x-1
0.15
y = 0.0075x-0.75
0.10
0.05
0.00
0
0.1
0.2
0.3
Grow th Rate
0.4
0.5
0.6
2002 CapR per Growth
2001 CapR per Growth
y = 0.0061x -0.8723
y = 0.0095x -0.7163
0.120
0.160
0.140
0.100
0.120
CapR
CapR
0.080
0.060
0.100
0.080
0.060
0.040
0.040
0.020
0.000
0.00%
0.020
10.00%
20.00%
30.00%
0.000
0.00%
40.00%
10.00%
Grow th
20.00%
2004 CapR per Growth
y = 0.0116x -0.4416
y = 0.0067x -0.7037
0.070
0.060
0.050
CapR
CapR
40.00%
Grow th
2003 CapR per Growth
0.100
0.090
0.080
0.070
0.060
0.050
0.040
0.030
0.020
0.010
0.000
0.00%
30.00%
0.040
0.030
0.020
0.010
10.00%
20.00%
Grow th
30.00%
40.00%
0.000
0.00%
10.00%
20.00%
Grow th
30.00%
40.00%
Historic Market Averages
Based on Damodaran Industry Averages
Year
Variable
Exponent
2001
.0095
.7163
2002
.0061
.8723
2003
.0116
.4416
2004
.0067
.7037
Average
.0085
.6835
Estimate
.0075
.7500
“The valuation of a privately
owned company is both
science and art.”
http://www.vrbusinessbrokers.com/pages/mergers/valuation_services.jsp
“Of course, bullish market observers argue that
times have changed. Specifically, they believe
that some of these older valuation models are
less relevant today because interest rates are
so low. According to an economic model of
stock valuations known as the Fed Model, lower
interest rates can help support higher valuation
levels in the market.” Paul Tracy
http://www.zacks.com/experts/featured/view_article.php?art_id=1587&newslett
er_id=148
Problems with comparing PE ratios
to expected growth
• In its simple form, there is no basis for believing that a
firm is undervalued just because it has a PE ratio less
than expected growth.
• This relationship may be consistent with a fairly
valued or even an overvalued firm, if interest rates are
high, or if a firm is high risk.
• As interest rate decrease (increase), fewer (more)
stocks will emerge as undervalued using this
approach.
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/peg.htm
Variable Relationship
0.012
Variable
0.01
0.008
0.006
y = 0.0005x + 0.005
R2 = 1
0.004
0.002
0
0
2
4
6
Interest Rates
8
10
12
Exponent Relationship
0
0
2
4
6
8
Exponent
-0.2
-0.4
y = -0.05x - 0.5
R2 = 1
-0.6
-0.8
-1
-1.2
Interest Rates
10
12
The Gaylen Curve
Cap Rate = (.0005r + .005)g-(.05r + .5)
Cap Rate = (ke – g)
r = interest rate (risk adjusted)
g = growth rate
Portfolio managers and analysts sometimes compare
PE ratios to the expected growth rate to identify
undervalued and overvalued stocks. In the simplest
form of this approach, firms with PE ratios less
than their expected growth rate are viewed as
undervalued. In its more general form, the
ratio of PE ratio to growth is used as a measure
of relative value, with lower values believed to
indicate undervaluation relative to other firms.
Peters, DJ. (1991) Valuing a growth stock.
Journal of Portfolio Management 17:49-51.
http://dignet.home.mindspring.com/limitsofpeg.htm
Peters (1991) provides a simple test of this
proposition by classifying firms into deciles based
upon the ratio of PE ratio to expected long-term
growth, for every quarter from January 1982 to June
1989. The lowest PE/growth decile outperformed the
market in 26 out of the 30 quarters for which returns
were measured and earned significantly higher
returns than the Standard and Poors 500. The
compounded return over the period was 1,536% for
the lowest PE/growth decile, while the return on the
S&P 500 index over the same period was 356%.
Peters, DJ. (1991) Valuing a growth stock.
Journal of Portfolio Management 17:49-51.
http://dignet.home.mindspring.com/limitsofpeg.htm
The PE ratio of a high-growth firm is a function of the
expected extraordinary growth rate; the higher the
expected growth, the higher the PE ratio for the
firm. The PE ratio can be graphed as a function of
the extraordinary growth rate. In Figure 14.1, as the
firm's anticipated extraordinary growth rate in the first
five years declines from 25% to 8%, the PE ratio for
the firm also decreases from 28.75 to 15.
Peters, DJ. (1991) Valuing a growth stock.
Journal of Portfolio Management 17:49-51.
http://dignet.home.mindspring.com/limitsofpeg.htm
PE Ratio versus growth: The effect of
interest rates and risk
In Figure 14.1 the Treasury bond rate used was 6%.
The effect of increasing the Treasury bond rate on PE
ratios is examined in Figure 14.2. As illustrated in the
graph, the PE ratio for this firm is lower than the
expected growth rate when the Treasury bond rate is
greater than 7%, though it is not undervalued. For
instance, the PE ratio will drop to 11.96 if the
Treasury bond rate increases to 10%, well below the
expected growth rate of 25% in the first five years
but still correctly valued.
Peters, DJ. (1991) Valuing a growth stock.
Journal of Portfolio Management 17:49-51.
http://dignet.home.mindspring.com/limitsofpeg.htm
The danger of concluding that a firm is undervalued
just because its PE ratio is less than its expected
growth rate is that it may be the wrong conclusion for
high-risk (high-beta) firms or when interest rates are
high.
Consider two firms with the same expected growth
rates of 25% for the first five years and 8% after
that, the same payout policies (payout ratio in the
first five years of 20% ; 50% thereafter), but different
levels of risk (beta of 1.0 for the first firm and 1.5 for
the second). The PE ratio of the safer firm will be
higher than the PE ratio of the riskier firm at every
level of growth, as illustrated in Figure 14.4.
Peters, DJ. (1991) Valuing a growth stock.
Journal of Portfolio Management 17:49-51.
http://dignet.home.mindspring.com/limitsofpeg.htm