A useful PEG to put your shirt on

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As regular readers know, the central theme of my approach to investment is to search for growth companies that have low price-earnings ratios in relation to their growth prospects. The average leading growth share sells on a forward p/e ratio of 15.5, which is 1.2 times the prospective growth rate of about 13 per cent.

I call the figure of 1.2 the price earnings growth (PEG) factor, and I use it to measure whether a growth company's shares are cheap or dear in relation to its future growth prospects. Most of the shares I have recommended in this column have attractively low PEGs - Amersham, Sage, Motor World, British Data Management, Ingham, Shoprite and Micro Focus. With the exception of Shoprite, all of these companies also have positive cash or very little debt. As their annual and interim results filter through into the market and their quality becomes better appreciated, their PEGs should increase from below average to above average. This status change in the multiple is the extra dimension I am always seeking. Increased earnings take the shares up first and then the uplift in the market rating compounds the gain.

Take the simple example of a company growing at 25 per cent per annum on a multiple of 15. The PEG would be an attractive 0.6. When the company delivers the next instalment of 25 per cent growth in earnings, provided the future outlook remains the same, the shares should duly increase by at least 25 per cent. However, at that point, institutions, brokers and the press might reassess the shares and agree that a multiple of 25 would be more appropriate. As a result, the increase of 25 per cent in the share price would increase to a total gain of 108 per cent, of which 83 per cent would be due to the status change in the p/e ratio.

A further advantage of buying shares on low PEGs is that there is also a greater degree of safety. A company that is already lowly rated in relation to its future earnings prospects is obviously a safer investment than one that is relatively highly rated. Reuters, for example, has great growth prospects, but the PEG is 1.4; the company may still be a good investment, but not much of any future capital gain will be due to a status change in the PEG.

A final thought on PEGs. Very fast-growing companies, such as Shoprite, often seem expensive at first sight. The historic multiple is usually very high. For example, in June Shoprite's historic multiple, based on a price of 143p and earnings for the year ended October 1992, was about 38. However, the interim results announced on 23 June showed that earnings per share were up by more than 50 per cent. The lower prospective multiple for the year ending October 1993 instantly became the focus of attention. When the results for 1993 are announced in December, investors will become more interested in the profits for the year ending October 1994. If, as I expect, earnings are still growing at an exceptional rate, the shares should then look very cheap on a prospective multiple of around 20.

In my book, The Zulu Principle, I compare this kind of status change with a relay race in which the focus of attention switches, as the baton passes, from the runner in the last lap to the runner in the next. This happens with all shares, but for those growing at only 10-15 per cent per annum, it is something of a nonevent. With fast-growing shares, it can produce a bonanza for investors.

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

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