David Einhorns Speech

Value Investing Congress

November 15, 2005
How to make money through the proper application of the PEG ratio
Peter Lynch is one of the greatest investors of all time. As a professional investor he
clearly had all the analytical skills to properly value stocks and identify superior
opportunities. He combined smarts and energy to be one of the best stock pickers of a
generation. He realized that non-professional investors who dont have 100 hours a week
to devote to selecting the best portfolio of stocks couldnt do everything that he could and
they may not have the access or technical skills that he did.
Nonetheless, he believed that he could contribute some basic investing skills to the
average, or even above average, individual investor. So he wrote a best selling book
called One Up on Wall Street. I read it years ago. It was an excellent book. The thesis
was that if you identify companies that are doing great on Main Street, you will do well
with them on Wall Street.
My Grandma Cookie used to love to invest in stocks. This was the basic advice she
followed. When she saw all her grandkids in NIKEs, she bought the stock. When she
passed away a few years ago, I had a chance to look over her portfolio. She had done
pretty well for a non-pro. She built a portfolio filled with blue chip growth companies
like, NIKE, IBM, AT&T (when that was a good thing), believe it or not McDonalds and
best of all WalGreens. She would buy these stocks bit by bit over decades and hold
forever.
She did much better than my Grandpa Ben, who has spent most of his retirement
constantly checking the markets. He subscribes to about a dozen news letters and cites
the latest thinking of his favorite gurus at all family events. He is a Goldbug and has
been waiting for the economic ruin of our country through a paper money, deficit driven,
hyper inflation at least since I was ten. Grandpa Ben decries our lack of sound money.
Grandpa Ben owns gold bullion, gold stocks, mining companies, options on gold and
gold stocks. Grandpa Ben is one of the best people I know, one of the nicest people I
have ever met. But Grandma Cookie coming out of the Peter Lynch school beat the pants
off him as an investor for thirty years. For individual investors, I would bet on Grandma
Cookies style for the next thirty, as well.
Nonetheless, I digress. Coming back to Peter Lynchs book. It really tried to avoid a lot
of technical valuation skills. He realized that those were either beside the point or likely
beyond the attention span of the mass audience he was writing to. But he threw in a
valuation hint, a rule of thumb if you will. He advised individual investors to pay just a
little attention to the possibility that when you identify a company doing well on Main
Street, take a moment to check to make sure that Wall Street hasnt already figured it out.
He advised investors to figure out how fast the company is growing its earnings and

compare it to the Price/earnings ratio. If the PE ratio was greater than the growth rate, it
was probably too late to join the party.
The wonder of this analysis is its simplicity. You can compare a growth rate with a PE
ratio in about 5 minutes -- or less. I dont know if Grandma Cookie did this, but I know
if she wanted she could. A good thing, too, because Id bet Grandma Cookie had about
the same chance of properly constructing a discounted cash flow analysis that I had of
carrying on Robin Younts legacy as the star of the Milwaukee Brewers.
As best I can tell, Peter Lynchs description is the genesis of the PEG ratio. What is the
PEG ratio? Simply defined, you calculate two numbers. First the trailing PE ratio and
second the expected growth rate of earnings for the next five years. Convert the growth
rate from a percentage to an integer, so 15% becomes 15. Now divide the PE ratio by the
growth rate and you have a PEG ratio. So a PE of 20 and a growth rate 10% gets you a
PEG ratio of 2. A PE of 10 and a growth rate of 20% gets you a PEG ratio of one-half.
For todays discussion, I am going to stick to this classical definition. I have seen
ridiculous concoction of this ratio using three-year growth rates or forward PE ratios. Etc.
I have seen analysis that says, this company is going to grow its earnings 40% next year
to $1 so it should trade at $40 using a PEG ratio of 1. Obviously, this is a big problem,
because even if the earnings grow 40% for 1 year, the following year may not be so good
and a slightly lower subsequent growth rate, might lead to a lower stock price using the
PEG methodology. Look what happens to this math when the earnings only grow 20% to
say $.85would that make the stock worth $17. So if you thought it was worth $40, a
modest shortfall might cost you more than half your investment.
Picking on abuses of the PEG ratio is too easy. Everyone knows them when they see
them. Id like to spend a few minutes on the classical PEG ratio. This a ratio that is
seldom analyzed but widely used. In fact, Merrill Lynch conducts an annual survey of
professional money managers where they ask them what factors they consider when
making stock selections. Mind you, these arent individuals. These are the Pros. The
survey gives them 26 metrics to chose from: PE ratio, Price to Book, Price to Sales, ROE
etc. According to Merrill Lynchs 2003 survey, the number 1, most common used metric
by Pros is the PEG ratio. In 2004 PEG fell to third, narrowly behind EPS surprises and
Price to Cash Flow. Nonetheless, 43% of professionals admit to considering the PEG
ratio when selecting stocks. In contrast, only 33% use PE ratios and only 25% use
dividend discount models. There were 201 pros surveyed, with one-third foreign. PEG
analysis appears to be disproportionately an American phenomena. Well over half the
US participants use PEG and it was easily the number 1 factor used by American
professionals.
Why do the Pros use it? I think for the same reason, Grandma Cookie might have used it:
Because they can calculate it quickly. Pros are lazy just like everyone else. They are
busy people with management meetings to attend and theyd rather get the answer
quickly. You can get a PEG ratio much quicker than a well-conceived DCF valuation.

So since, this is the most commonly used ratio on Wall Street, I thought that while we are
all here together today we could examine the PEG ratios theoretical underpinnings as
they relate to finance theory.
There are none. Phew! That wasnt hard.
Now lets look at some of the problems with the PEG ratio. First, is that simply telling
you what the PEG ratio is does not tell you anything. If a stock has a PEG ratio of 3, I
dont know if that means it is cheap or expensive. If the PE ratio is 60 and the expected
growth is 20, I would conclude it is expensive and should be avoided. If the PE is 12 and
the expected growth is 4, I would conclude it is reasonable. If the PE is 3 and the
expected growth rate is 1, I would conclude that it is an obvious bargain, as paying 3
times earnings that are stable is a great way to make a fortune.
If you tell me any other measure, it immediately tells me something. A PE of 5 means
something. 3 times book value means something. Ten times EBITDA means something.
A PEG ratio of 1 means nothing.
Next, to the extent that there is a relationship between proper PE multiple and earnings
growth, I would submit to you that it is non-linear. If you look at the capital asset pricing
model, the theory for valuing perpetual growth is PE = 1/(r-g) where r is the cost of
equity and g is the perpetual growth rate. If you were to try to graph this you would get
an asymptotic curve. Now admittedly, the PEG ratio only purports to cover 5 years of
growth, rather than through perpetuity. Nonetheless, it is a linear relationship. At best
you are trying to fit a line through a curve. Any good 10th grader will tell you that would
intersect the curve in no more than two points. In most places it is nowhere near the
curve. It just gives you the wrong value.
Next, a PEG ratio does not tell you anything about the quality of the growth. Put simply,
earnings growth happens three ways and they are of vastly different quality. The best
kind of growth is organic top line unit growth. Companies that grow by doing more of
whatever they do are the most valuable. Investors, can, should and do pay up for this
kind of growth. It is generally hard to find and in the best cases, it is open-ended. What
is the maximum number of sneakers for Nike, hamburgers for McDonalds or targeted
adds on the internet for Google?
The next best type of growth is through margin expansion. Margin expansion is good. It
rarely requires additional capital. Whether it comes from pricing power, economies of
scale or cost cutting it is nice. The problem with margin expansion versus, unit growth,
is it isnt open ended. Most businesses can only improve margins to a certain extent.
Eventually, they cant push price, they operate at optimal scale and there is no fat left.
Nonetheless, improving earnings through expanding margins is a good way to grow
earnings for a period of time.
The third way, and least valuable, to create earnings growth is by leveraging the balance
sheet. Sometimes this passes as top line growth through acquisitions or excess capital

investment. Sometimes it comes from leveraged recapitalizations through one means or

another or incrementally over time through share repurchases. However achieved, this
form of earnings growth is least valuable. Not only is it inherently unsustainable the
growth rate, not the earnings in that companies can only leverage to a certain degree,
but such growth should be rewarded with a shrinking p/e multiple as the risk to the
enterprise grows and the cost of equity correspondingly should increase.
It is true that sometimes the market doesnt recognize the distinction and rewards this
growth with an undeserved rich multiple. However, that is a difference between what the
market should do versus what it does do. Smart investors can make the distinction and
avoid paying up for situations like these where higher growth comes with higher risk.
Personally, I like to sell short these type of situations.
That the PEG ratio doesnt distinguish between types of growth is a tremendous flaw.
What is worse, it doesnt distinguish between secular growth and cyclical growth.
Secular earnings growth represents permanent expansion of earnings power. Cyclical
growth represents temporary growth aided by favorable cyclical tailwinds. Just so we
arent confused, cyclical growth can come from either a favorable macro environment or
a favorable circumstance for the company at hand, such as a hot product. Obviously,
secular earnings growth that sustains itself at growing levels ought to be rewarded with a
much better multiple than growth aided by cyclical or temporary factors.
When you put all this together, it isnt even clear to me that higher earnings growth
should always be rewarded a higher multiple. Sometimes it should be rewarded with a
lower multiple. I would take this to the point of arguing that if you have two companies
at 15 times earnings and one is expected to grow 15% for the next five years and the
other is expected to grow 10%, it isnt entirely clear to me that the 15% grower should
get ANY premium over the 10% grower. It all depends on the circumstances.
If you agree with me on this, the only thing to conclude is that the PEG ratio has no value
and is never genuinely informative in determining valuation.
PEG adherents will invariably respond to such criticism by claiming that the PEG ratio
isnt the only thing they look at. I, of course, respond, Yes, but why do you use it at
all?
The PEG ratio leads to the systemic misevaluation of companies. This creates
opportunities for investors who use sound valuation technique. The way to make a lot of
money using the PEG ratio is to allow others including a lot of lazy Professionals, to
use it.