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Despite its increasing popularity as a valuation tool, the academic literature on the PEG ratio is
scarce. The pioneering study seems to be by Peters (1991), who focused on the compounding
power of PEG-sorted portfolios. He found that between January 1982 and June 1989, $1 invested
in the lowest-PEG portfolio, rebalanced quarterly, would have turned into $15.36, whereas $1
invested in the highest-PEG portfolio, also rebalanced quarterly, would have turned into just
$1.38. (In the same period, $1 invested in the S&P500 turned into $3.56.)
More recently, Sun (2001) found that PEG ratios and stock returns were negatively related \
during the period July 1983-June 2000, though the significance of the relationship largely stems
from the first half of the sample. He also finds a hump-shaped relationship between PEG-sorted
portfolios and returns, with low-PEG portfolios and high-PEG portfolios earning lower returns
than mediumPEG portfolios.
These results are not very supportive of the PEG as a valuation tool and cast doubt on a low-PEG
value strategy.
Easton (2002), in contrast, reports more optimistic results. He proposes a method to
simultaneously estimate expected returns and earnings growth (thus refining PEG-based
rankings), and finds that expected return estimates based on the PEG are highly correlated with
those based on the refined methodology. He concludes from these results that PEG ratios are a
reasonable first-order approximation to a ranking on expected returns.
P0 =
Where,
(1)
P0 =
-[ -
] _________(2)
If expected accounting earnings eps1 is equal to economic earnings (which may be defined as
rP0), the term in square brackets must be equal to zero in other words, next periods expected
earnings are sufficient for valuation. However, if eps1 does not equal economic earnings,
valuation based on accounting earnings requires forecasts beyond the next period.
The role of forecasts of accounting earnings two periods ahead may be seen by rewriting
equation (2):
P1 =
[ -
] ________(3)
P0 =
+
(
+
(
_____(4)
(
Where,
ae1 = eps2 +r*dps1 (1+r)*eps1
(5)
This abnormal earnings reflects the effects of generally accepted accounting practices that lead to
a divergence of accounting earnings from economic earnings. To see this note that if eps 1 and
eps2 were equal to economic earnings ae 1 would be zero and the ratio of expected earnings-toprice would be equal to the expected rate of return.
The valuation role of expected accounting earnings beyond the two-year forecast horizon may be
seen by recursively substituting for P2, P3, P4, etc., in (4) & (5) to yield:
P0 =
(6)
(
Where,
aet = epst+1 + r*dpst + (1+r)*epst
Hence, by considering a perpetual rate of change of abnormal earning,
P0 =
(8)
(
At ae = 0,
r2 r*
At, dps = 0,
r=
P =
If, g = g = g3 = . = g
P
dps = b * eps ;where, b = payout ratio
Assumptions,
(7)
=0
P0 =
=>
Valuation of a company,
Next, we introduce our general model for a firms market value of equity (a.k.a. market cap).
This model allows for growth in earnings and introduces the concept of normal versus
abnormal earnings. The market value of a firms equity at time t (P) is:
P = BV0 +
(
When,
Abnormal Earning = Economic Profit
If eps1 and eps2 are equal to economic earnings, the expected rate of return is equal to the ratio of
forecasted earnings-to-current price. If eps1 and/or eps2 are not equal to economic earnings, ae1
will be non-zero and ae captures the future change in abnormal accounting earnings to adjust
for this difference between accounting and economic earnings.
Hypothesis
H0: Growth in EPS reflects to expected Rate of Return of a Company
H1: Growth in EPS doesnt reflects to expected Rate of Return of a Company
Research Design
The EPS, Share Price of 15 different companies listed on NSE are taken as research data.
Table1: EPS Growth and Cost of Equity
Company
Growth EPS
Average(r)
Hindalco
Nalco
Hindustan Motors Ltd
Maruti Suzuki India Ltd
ABC Bearings Ltd
NRB Bearings Ltd
SKF India Ltd
Timken India Ltd
ACC Ltd
Birla Corporation Ltd
UltraTech Cement Ltd
India Cements Ltd
Madras Cements Ltd
Gammon India Ltd
Hindustan Construction Company Ltd
0.134564916
0.112586699
0.116392893
0.422840729
0.225270093
0.127187869
0.338166297
0.055476462
0.478893534
1.010931868
0.327987861
0.248285039
0.259541641
0.220778143
0.058427682
0.155698158
0.203925055
0.256234244
0.139249937
0.409633364
0.193776586
0.161712438
0.119055724
0.155653519
0.256373807
0.174731423
0.354324878
0.187924484
0.167030028
0.261464189
SUMMAR
Y OUTPUT
Regression Statistics
Multiple R
R Square
0.0329399
0.001085037
Adjusted R -0.075754576
Square
Standard
0.248921116
Error
Observati
15
ons
ANOVA
df
SS
MS
Regressio
n
Residual
0.0008
75
0.0619
62
0.0141
21
Total
14
0.0008749
49
0.8055023
85
0.8063773
35
Standard
Error
0.1855718
78
t Stat
P-value
1.3748
59
0.1924
09
0.8168508
42
0.1188
31
0.9072
26
13
Coefficients
Intercept
0.255135234
Average(r)
0.09706719
Significan
ce F
0.907226
Lower
95%
-0.14577
Upper
95%
0.6560
39
-1.66763
1.8617
66
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.100078999
Average(r)
0.1556982
0.2039251
0.2562342
0.1392499
0.4096334
0.1937766
0.1617124
0.1190557
0.1556535
0.2563738
0.1747314
0.3543249
0.1879245
0.1670300
0.2614642
PEG
0.782596
1.378404
3.219784
0.294764
0.251387
1.05812
0.457024
3.321228
0.35321
0.095654
9.321168
1.429365
0.714606
1.135303
4.403563
Lower
95.0%
0.145
77
1.667
63
Upper
95.0%
0.6560
39
1.8617
66
R Square
Adjusted R
Square
Standard
Error
Observati
ons
0.010015806
-0.066136824
2.507479818
15
ANOVA
df
SS
MS
Regressio
n
Residual
0.8269
44
6.2874
55
0.1315
23
Total
14
0.826943
602
81.73691
551
82.56385
912
Standard
Error
1.869338
151
t Stat
P-value Lower
95%
0.2011 -1.5214
51
Upper
95%
6.5555
15
8.228458
209
0.3626
6
0.7226
86
14.792
36
13
Coefficients
Intercept
2.517055682
Average(r)
-2.984138441
1.3464
96
Significa
nce F
0.722686
-20.7606
Lower
95.0%
1.521
4
20.76
06
Upper
95.0%
6.5555
15
14.792
36
Conclusion
We described a model of earnings and earnings growth and we demonstrated how the model may
be used to obtain estimates of the cost of equity capital. We developed and demonstrated a
procedure for simultaneously estimating the implied market expectation of the rate of return and
the implied market expectation of the long-run change in abnormal growth in earnings for a
portfolio of stocks. Our finding is despite of having a high expected rate of return the companies
are not having high eps growth. Hence the Price of the company gets affected. Though in a few
companies the eps grew significantly resulting in overvaluation. The general downward bias in
the estimate of the expected rate of return based on the PEG ratio is shown to be higher for firms
with higher PE, higher PEG ratios, lower standard deviation of past returns, higher market
capitalization, and lower expected short-term earnings growth rates.
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pegrowth
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