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Good ratio, bad ratio
I recently added a page on the naked PE to Money Terms. A post in response to this by Richard Beddard (thanks to whom I came across the ratio in the first place) lead me to a clearer description of why it is good — and why the PEG is bad.
Consider this approach to stock picking. You identify growth shares by looking at current growth. You do not look at past growth, future growth, or any indications of how sustainable current growth is. From these supposed growth companies you buy those on low PE ratios.
It is fairly clear that this is not good practice. What the PEG ratio does is to formalise exactly this approach by reducing it to a ratio.
Now consider another approach. You identify value shares by looking at long term PEs. You further adjust the PEs by making them sector relative. This is a reasonably common approach, and it is a good one. As a, less common, twist on this you could add an adjustment for company size as well. Naked PE formalises this approach.
The little known naked PE formalises a sound approach. The better known PEG formalises an unsound one. Maybe it is time the naked PE was better known?
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