PEG ratio, FCF yield and dividend yield

Key takeaways

• PEG equals the P/E ratio divided by expected annual EPS growth in percent; it is a rough screen, not a valuation model.
• PEG ignores dividends, risk and the duration of growth, so it systematically penalizes high-payout, low-growth companies; PEGY adds dividend yield to growth.
• Levered FCF yield (levered FCF over equity value) pairs with equity; unlevered FCF yield (unlevered FCF over EV) pairs with enterprise value.
• Dividend yield equals dividends per share divided by price; payout ratio equals dividends divided by earnings, and should also be checked against free cash flow.
• Total shareholder yield adds net buybacks, and sometimes net debt repayment, to dividends, which matters for companies that return cash mainly through repurchases.

The PEG ratio

The price/earnings-to-growth ratio, or PEG, divides a company's P/E by its expected annual growth rate in earnings per share, with growth expressed as a whole number (15 for 15 percent). The idea is that a high P/E may be reasonable if earnings are growing quickly, so dividing by growth puts fast and slow growers on a comparable footing. A PEG of 1.0 means the P/E equals the growth rate; a lower PEG means less is being paid per unit of growth.

The growth rate is usually a consensus or analyst forecast for the next three to five years. State the period and the P/E basis. A forward P/E divided by growth that starts from next year's earnings uses the earnings growth twice if the forecast period overlaps, so practitioners pick one convention and apply it across the peer set.

The widely quoted rule that a PEG below 1.0 signals value is a heuristic associated with growth investors, not a result from valuation theory. It is best treated as a way to sort a list of companies for further work.

Why PEG misleads: risk, duration and dividends

The justified P/E from the Gordon growth model is payout / (r - g). The multiple rises with growth in a sharply non-linear way as g approaches the cost of equity, and it also depends on payout and on r. PEG replaces that relationship with a straight line through zero. Three consequences follow.

First, PEG ignores risk. Two companies with the same P/E and growth forecast get the same PEG even if one has a far more reliable earnings stream. Second, it ignores duration. A company growing 20 percent for two years and one growing 20 percent for ten years have the same PEG, but very different values. Third, it ignores dividends. Returns to a shareholder come from growth plus cash paid out. A utility growing earnings 4 percent a year while paying out three quarters of them delivers much of its return as dividends, which PEG leaves out, so PEG makes such companies look expensive by construction.

A partial fix for the third problem is the dividend-adjusted PEG, sometimes called PEGY, which divides P/E by growth plus dividend yield. It does nothing for risk or duration. PEG also becomes meaningless for companies with negative or very low expected growth, where the ratio turns negative or explodes.

Free cash flow: levered and unlevered

Free cash flow (FCF) is cash generated by the business after the investment needed to sustain and grow it. Unlike EBITDA or net income, it is charged for capital spending, working capital and cash taxes. There are two main definitions, and they belong to different sides of the consistency rule.

Levered free cash flow is the cash available to equity holders after lenders have been paid interest. The common practitioner shortcut is cash flow from operations less capital expenditure. Under US GAAP, operating cash flow already deducts interest paid, so the result is after interest. (Under IFRS, companies may classify interest paid in operating or financing activities, so check before using the shortcut.) The textbook free cash flow to equity also adds net borrowing, because new debt raised is cash available to shareholders; many practitioners leave it out to avoid rewarding a company for borrowing.

Unlevered free cash flow is the cash available to all capital providers, before any interest. It is built from EBIT: tax it at the operating tax rate as if the company had no debt, add back D&A, and deduct capex and the increase in net working capital. It is the cash flow discounted in a DCF at the weighted average cost of capital. A quick bridge from the levered version adds back after-tax interest expense and removes after-tax interest income.

Because levered FCF belongs to equity holders, it is divided by equity value. Because unlevered FCF belongs to all capital providers, it is divided by enterprise value. The yield is the inverse of the corresponding multiple.

Cash conversion: comparing FCF with earnings

Comparing the FCF yield with the earnings yield shows how much of reported profit becomes cash. A company whose FCF yield is well below its earnings yield is converting less than all of its earnings into cash, usually because capex exceeds depreciation (it is investing for growth or its assets are underdepreciated) or because working capital is absorbing cash. One whose FCF yield exceeds its earnings yield converts more than all of its earnings, usually because of large non-cash charges such as amortization or share-based compensation, or because it collects cash from customers in advance.

Neither is automatically good or bad. A utility building new capacity will convert less than all its earnings for years, and that investment will earn a regulated return. A software company that looks cash generative because it pays employees heavily in stock is shifting a real cost onto shareholders through dilution; many analysts deduct share-based compensation from FCF for that reason.

Dividend yield and payout ratio

Dividend yield is the annual dividend per share divided by the share price. It is usually based on the most recent annualized dividend (for example, the latest quarterly dividend times four) or on the dividends paid over the last twelve months; forward yields use the expected dividend. Special one-off dividends are normally excluded from the headline yield.

The payout ratio is dividends as a share of earnings. It tells you how much of profit is distributed and how much is retained to fund growth. A high payout is sustainable for a mature company with modest reinvestment needs, but it leaves little room to maintain the dividend if earnings fall.

Because dividends are paid in cash, not earnings, the payout ratio should also be checked against free cash flow. A company paying out 75 percent of earnings but 100 percent or more of its free cash flow is funding part of its dividend with borrowing or asset sales, or relying on capex falling in future. That is the pattern to question before treating a high yield as reliable income.

Buybacks and total shareholder yield

Many companies, especially in the United States, return more cash through share repurchases than through dividends. A dividend yield alone understates what these companies give back. Total shareholder yield adds the buyback yield, net repurchases divided by equity value, to the dividend yield.

Use net buybacks: shares repurchased less shares issued to employees on exercise of options and vesting of stock awards. A company that buys back shares only to offset the dilution from stock compensation is not reducing its share count, and counting its gross repurchases as a return to shareholders double-counts a cost it already pays in shares.

Some definitions go further and add net debt repayment, on the grounds that paying down debt transfers value from lenders to shareholders by reducing claims ahead of them. State which version is used. The broad version favors deleveraging companies, and the narrow version favors those that pay cash directly to owners.

Putting the measures side by side

The table below gathers every measure for the two companies. It shows why no single figure settles a comparison. Halden looks expensive on PEG, cheap on P/E, generous on dividend yield and levered FCF yield, and stretched on FCF payout. Corvid looks expensive on P/E, reasonable on PEG, and cheaper on the unlevered FCF yield that strips out Halden's leverage.

For a screening workflow, the practical approach is to choose measures that match the question. For income-oriented mandates, dividend yield with FCF payout and leverage. For growth mandates, PEG as a first sort, followed by a DCF. For comparing businesses regardless of financing, unlevered FCF yield alongside EV/EBIT. For companies returning cash mainly through buybacks, shareholder yield rather than dividend yield.