Pop quiz: Who can tell me the definition of a PEG ratio? If you read last weeks article entitled Valuing Stocks Using the PEG Ratio (who didnt?), you know its the price-to-earnings ratio divided by a forward estimate of earnings growth. Its a useful gauge, but it only tells part of the story after all, the value of a company doesnt hinge solely on current earnings and future annual earnings growth.

Cash Dividends are King

In fact, the real McCoy of value is not earnings at all it is cash dividends. If you think about it, the only reason to buy a stock is to receive cash returns on your investment. You cant eat earnings growth unless it is paid out to you in cash. And often, earnings on a companys income statement arent paid out but simply get frittered away in future reporting periods. As Wharton finance professor Jeremy Siegel wrote in his classic investment book Stocks for the Long Run :

The price of a stock is always equal to the present value of all future dividends and not the present value of future earnings. Earnings not paid to investors can have value only if they are paid as dividends or other cash disbursements at a later date. Valuing stock as the present discounted value of future earnings is manifestly wrong and greatly overstates the value of a firm.

Investing Dailys dividend expert Roger Conrad goes even further, saying that current cash dividends are worth at least twice the value of uncertain future growth estimates.

High Earnings Growth Can Mean High Risk

Furthermore, companies reaching for abnormally high growth often are taking large risks to achieve it incurring debts and making expensive capital expenditures that could pan out for a while but often end up destroying value in the long term. Other high-growth companies have found a new, unexploited niche product that gives them a temporary monopoly and the high profit margins that go with such status, but this monopoly and the high growth that accompanies it evaporates once larger-capitalized competitors take notice and enter with their own similar or superior products.

It is the instability that often accompanies the quest for high growth that leads NYU finance professor Aswath Damodaran to conclude:

The PEG ratio is biased against low growth firms because the relationship between value and growth is non-linear.

What does Damodaran mean by non-linear? He means that higher earnings growth does not lead to a commensurate increase in a companys value. Value may increase at first, but any increase will be less than 1-for-1 with the increase in growth because of the higher risk associated with higher-growth companies. At some point, higher growth will actually destroy value. A chart with value on the Y-axis and earnings growth on the X-axis has a concave-down shape.

Dividends Create Value

Enter the importance of dividends. As I wrote in The Best Stocks are Dividend Stocks . companies that pay dividends typically have higher earnings growth than non-dividend payers. This is because the dividend payments impose fiscal discipline on corporate management and prevent them from wasting money on wasteful, low-return investments. Of course, paying extremely high dividends can be unsustainable and increase risk just like reaching for extremely high earnings growth can be. The key is a happy medium, where a combination of dividends and earnings growth provides the best opportunity for maximized value creation.

As professor Damodaran writes, companies with low earnings growth tend to have higher PEG ratios than high-growth companies precisely because these low-growth companies are less risky. Investors are willing to value each earnings dollar of these steady Eddies more highly because they view the earnings as more sustainable. Consequently, comparing companies based on PEG ratios alone will result in low-growth, dividend-paying companies appearing overvalued compared to high-growth companies when in fact the dividend payers are simply safer investments.

Take, for example, the following chart which uses the PEG ratio to compare high-growth companies to dividend-paying companies. The high-growth companies appear much cheaper on a PEG basis, but are much riskier (Beta is a measure of risk):