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ABSTRACT
This study investigates the use of a simple trading heuristic, the PEG ratio, to value stocks. Our results indicate that a trading strategy implementing accounting-based intrinsic value calculations yields greater one-year stock returns for a subsample of firms priced fairly according to the PEG as compared to returns from the same strategy applied to the overall market. Thus, identifying stocks priced according to the PEG heuristic creates a sample of firms which are more likely to have fundamental values that diverge from actual stock prices. These results provide preliminary evidence regarding the relationship between heuristics and market inefficiencies. Investors can profit by applying intrinsic value-based trading strategies to stocks currently priced in accordance with the PEG.
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INTRODUCTION
Prior research finds that intrinsic (i.e. earnings and cash flows based) valuation models are useful in identifying mispriced stocks and predicting future returns.1 The basis behind an intrinsic-value based pricing approach is that the fair value of an investment should reflect the present value of the cash flows that the investment generates. As Warren Buffet summarizes:
Intrinsic value is an all-important concept that öfters the only logical approach to evaluating the relative attractiveness of investments and businesses.2
Despite the fundamental nature of intrinsic value models, many analysts and investors appear to base recommendations and trading decisions on relatively simple heuristics. One heuristic commonly cited in the financial press as a useful tool for evaluating stocks is the PEG, or price-earnings-growth, ratio.
The foundation of the PEG as a pricing tool is rather straightforward, relying on the premise that the price-earnings (P/E) ratio of any company that is fairly valued will equal its expected earnings growth rate multiplied by 100. Thus, stocks trading at a PEG equal to 1.0 are considered fairly valued, or "holds". Stocks trading at a PEG of less than 1.0 are considered under-valued (i.e. "buys") and stocks trading at a PEG of greater than 1.0 are considered over-valued (i.e. "sells"). The greater the distance from 1.0, the more or less attractive the stock becomes. In line with the growth at reasonable price (GARP) philosophy, the idea is to target those stocks which are undervalued relative to their future earnings growth potential. Given estimates of growth and future...