The price/earnings to growth (PEG) ratio is a proven metric for investors looking to determine the value of an equity, but it needs to be tweaked when dealing with dividend stocks. That’s where the dividend-adjusted PEG ratio comes into play.
The dividend adjusted PEG ratio, or PEGY (price/earnings to growth and dividend yield) for short, is a modified version of the popular PEG ratio that accounts for dividend income. This crucial detail makes it easier for investors to compare the returns of mature companies and newly established high-growth companies.
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Understanding the PEGY Ratio
When PEGY was created by value investor Peter Lynch, it was designed to help investors factor a stock’s future earnings prospects as well as dividend yields. Like the PEG ratio, its primary goal is to help investors identify undervalued companies. Where it departs from the PEG ratio is in its ability to account for more than just earnings per share.
To illustrate: profitable companies have the ability to return most of their profits to shareholders in the form of cash dividends. This sometimes gives the illusion that the company is growing very slowly, when in reality shareholders are receiving big payouts. When this occurs, the PEG ratio is insufficient for evaluating whether a company is adequately valued. In other words, the PEG ratio might give the impression that such stocks are overvalued and should be avoided, when in reality they could be yielding big cash payouts that the indicator doesn’t consider.
To calculate the PEGY ratio, all one needs to do is divided the P/E ratio by the sum of the projected earnings growth rate and dividend yield.
For example, if a company has a P/E ratio of 10, a projected earnings growth rate of 20% and a dividend yield of 4%, its PEGY ratio is 0.42. That is:
10 / (20 + 4) = 0.42
In general, a PEGY ratio below 1.0 means a stock has a high dividend yield or potential growth and is currently undervalued as far as the price is concerned. Companies with a PEGY ratio below 1.0 are considered good investment opportunities.
To illustrate: Apple Inc. (AAPL) has a dividend yield of 1.18%, an expected growth rate of 10.77% next year (year ending September 2020) and a P/E ratio of 19.89. As a result, its PEGY is 1.66.
By comparison, Coca-Cola Co (KO) yields 3.09% and is expected to grow 7.14% next year. With a P/E ratio of 24.61, KO’s PEGY is 2.40.
Under this scenario, Apple is a more attractive company to invest in than Coca-Cola.
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In a purely theoretical world, all stocks would have a PEG ratio of 1.00 (that is, all companies will have a P/E ratio that is equal to the growth rate of their earnings per share). Of course, the real world rarely lines up with theory and many stocks often trade at much higher ratios. Stocks don’t trade in a vacuum, so factors like the economy, real interest rates and investor sentiment also play an important role.
Drawbacks of the PEGY Ratio
While PEGY was designed to address the shortcomings of the traditional price-to-earnings ratio, it’s not without its own drawbacks. For starters, it relies on a company’s projected growth rate, not the actual growth it achieves. As many of us have come to know all too well, actual results don’t always match forecasts. As a result, the PEGY ratio does not guarantee accuracy.
If you want to weed out the uncertainty, it’s helpful to use only operating and recurring income in the calculation of earnings and to rely on a lower consensus estimate for future growth rates. Analysts on Wall Street and elsewhere often give earnings estimates of a company each quarter. Using the lower end of the projected range could help you avoid any surprises if earnings don’t live up to projections.
Use the Dividend Screener to find high-quality dividend stocks. You can even screen stocks with DARS ratings above a certain threshold.
The Bottom Line
The dividend-adjusted PEG ratio is just another tool income investors can use to determine whether a particular stock is a worthwhile investment. When used in conjunction with other investment strategies and risk management principles, PEGY can take much of the guesswork out of picking quality companies.
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