Improving the PEG ratio

Abstract

The effectiveness of the PEG ratio as a valuation tool has been a topical debate between market commentators ever since being popularised by Lynch (1989). This study examines the appropriateness of the fair value criteria of 1.0 (PEGL) in comparison with a time-series based share specific benchmarking model (PEGT). Furthermore, influencing factors of analyst forecasting accuracy, namely: the number of analyst contributions, forecast dispersion and forecast horizon, were tested and compared using sub-set portfolios for each category with the objective of identifying a possible optimal PEG trading rule strategy. The outcome showed a consistent outperformance of PEGT portfolios compared to PEGL portfolios and the market benchmark. Unexpected results were obtained for the impact of analyst forecasts on the performance of the PEG ratio with additional literature review providing possible reasons that analyst optimism may have a more influencing impact on the PEG ratio than forecasting accuracy. Finally, an optimised PEG trading rule strategy delivered annual abnormal returns of 5.4% (CAGR: 19.7%) for a PEGL portfolio, versus that of 13.7% (CAGR: 28.5%) for a PEGT portfolio. The ensuing methodology appeared to single out small cap firms with above market growth prospects. Copyright