Pegging down the price of growth

As regular readers will know, I am very keen on an investment measure which I call the PEG factor. Every investor knows that fast-growing shares usually command high price/earnings ratios. The big question is, how high should they be?

The PEG factor gives a measure of how much you should pay for future growth. It is calculated by dividing the future growth rate into the prospective p/e ratio. If the resultant PEG factor is one or under, the share price is usually not excessive and the company merits further investigation.

It is then worth checking that all other things are more than equal; the level of debt, the cash flow and return on capital employed are among the first key criteria to check.

To give an example of a PEG calculation, the consensus forecast for Amersham International is for 20 per cent growth in earnings per share in the year to March 1995. The prospective multiple at 1024p is 19.1, so the prospective PEG is just under one. Amersham International is a very easy PEG to calculate because the financial year synchronises with the next 12 months ahead.

Euromoney, for example, is slightly more difficult because the financial year ends in September. It is, therefore, necessary to take six months from the current year's consensus forecast and six months from next year's.

The consensus forecast of EPS is 65p for the year ending September 1994 and 76.4p for the following year. Half of 65p is 32.5p and half of 76.4p is 38.2p, so for the 12 months ahead, the consensus forecast (based on three brokers' circulars) is 70.7p. At the present price of 1643p, the prospective p/e ratio for the 12 months immediately ahead is, therefore, 23.2.

The future growth rate needs calculating in a similar way. Six months at 14 per cent for the current year and six months at 18 per cent for the year ending September 1995 gives 16 per cent for the next 12 months. The resultant PEG is 1.45 (23.2 divided by 16), which is too expensive for my taste. However, Euromoney has often surprised the market with better than expected results, so the high rating may be justified.

My method of calculating prospective PEGs is a little rough and ready as it excludes interims; there is some logic in this as half- year results can be influenced by seasonal factors. Also, my method does not take into account accelerating and decelerating trends of earnings growth, although I always factor these into my thinking when considering the likely impact of future news-flow on the share price.

The PEG factor is not an appropriate measure for recovery situations or for the market as a whole, which contains so many of them. The PEG is ideal for comparing genuine growth shares; companies which churn out increased EPS year after year.

In my book The Zulu Principle, I suggested that there should have been a positive rate of growth in at least four of the last five years. However, I went on to say that there is no need to be absolutely dogmatic about the five-year record - a shorter period can suffice if there has been a recent sharp acceleration in earnings growth from an easily identifiable source (usually a change of management or a major new product).

During the last year or so, I have noticed that many of my best buys have been companies with shorter records. This is probably due to the fact that well established growth shares are often fully, if not excessively, rated by the stock market. Relatively new managements that have just begun to show their paces usually have to wait a few years for full recognition.

The author is an active investor who may hold any shares he recommends in this column. He has agreed not to deal in a share within six weeks before and after any mention in this column. Shares can go down as well as up.

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