Tuesday, August 20, 1996
A Once More With the DPEG
A constant refrain in the Dow area of late has been the concern that a stock identified as a good investment by the Dow Approach might appear woefully over-valued by the DPEG Ratio Price Target. As I've mentioned before, I prefer to put my faith (and investment dollars) in the tried and tested Dow Approach rather than rely on a theory with no history.
But there's another theoretical reason I have qualms with the DPEG Approach. The price target is artificially raised whenever a stock drops in price. Let's look at the recent example of Philip Morris. MO was trading at roughly $100 a share and paying $4 a share in dividends each year, giving it a 4% annual yield. With earnings estimates for next year of nearly $9 a share and a long-term estimated growth rate of 16%, here's how the price target is calculated:
Estimated Earnings X (Growth Rate + Yield)
9 X (16 + 4) = 180
So, Philip Morris' price target was approximately $180.
Now let's look at what happened when MO dropped 10% in price to $90 a share. Because the price dropped, the dividend yield increased to roughly 4.4%. (Remember that the yield is directly related to the price and dollar dividend.) But with the DPEG theory, that raised dividend yield is included in the multiplier we use with the earnings estimates. So now, let's calculate the new price target:
9 X (16 + 4.4) = 184
Now my question is why should the raw dollar price target move at all? It makes sense that a stock can become more undervalued when its price drops, all other things remaining equal, but that's accomplished simply by the price dropping even further below the target price. But the target price itself shouldn't go up simply because the price drops. The DPEG, as we've been calculating it, artificially inflates the target price based on an event which shouldn't affect the target. It doesn't make sense that a stock's intrinsic value should rise because it sinks in price. (It DOES make sense that a stock worth $100 is an even bigger bargain when it sinks from $80 to $70, but that drop in price shouldn't suddenly make the $100 stock worth $110.)
I'm not sure if there's an easy and reasonable way around this (other than to exclude the Yield in the price target and go back to the YPEG), but it does add even more doubt about the usefulness of the DPEG Ratio, at least as we've been tracking it. Personally, I'm sticking with the High-Yield, Low-Price Dow Approach, even when it means buying a stock that the DPEG tells me is too expensive. I'll trust that yield number first.
Transmitted: 8/20/96