Pe Ratios, Peg Ratios, and Estimating the Implied Expected Rate of Return on Equity Capital

I describe a model of earnings and earnings growth and I demonstrate how this model may be used to obtain estimates of the expected rate of return on equity capital. These estimates are compared with estimates of the expected rate of return implied by commonly used heuristics—viz., the PEG ratio and the PE ratio. Proponents of the PEG ratio (which is the price‐earnings [PE] ratio divided by the short‐term earnings growth rate) argue that this ratio takes account of differences in short‐run earnings growth, providing a ranking that is superior to the ranking based on PE ratios. But even though the PEG ratio may provide an improvement over the PE ratio, it is arguably still too simplistic because it implicitly assumes that the short‐run growth forecast also captures the long‐run future. I provide a means of simultaneously estimating the expected rate of return and the rate of change in abnormal growth in earnings beyond the (short) forecast horizon—thereby refining the PEG ratio ranking. The method may also...

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