It had to happen ...

Apple imploded yesterday. Fortunately i had no position in it. As one of the "four horseman" it is significant even though it had been getting pummeled for several weeks. The crux of the matter is that growth has slowed. When growth slows growth stocks get hammered. Why is this? Why do stocks with otherwise small outlook changes get hammered? The reason for this can be seen in the PEG (Price to Earnings Growth). The PEG Ratio provides the rationale for paying what seems an exorbitant price for current earnings. The "Annual EPS Growth" rate becomes a multiplier in determining price. Lets look at the PEG:

Price /Earnings
PEG Ratio = ----------------------
Annual EPS Growth

So let's say you have a stock trading at $100 per share that earned 2$ per share (trailing twelve months) P/E = 100/2 = 50, and is growing at 50% annual rate. The PEG ratio is:
PEG =50/50 = 1.

So in this case the market is willing to pay $50 per $1 of earnings because the growth rate is 50%. Another way to say this is the market will buy the stock to a PEG of 1.

Now let's say they meet the numbers but revise the outlook down such that the growth rate slows to 40%. What do we have. Note the P/E did not change as they met the numbers (a little bit simplified i admit).
the new PEG = 50/40 = 1.25

But the market still may only pay up for a PEG of 1 so now the stock is overpriced. What does the price go down to? We can solve for price and get this equation (note we use the orignal PEG the market was willing to pay aka 1, with the new Annual EPS Growth value)
P = Earnings x Annual EPS Growth x Orignal PEG = 2 x 40 x 1 = $80

So this is how a "rational" market gives a stock in a good company, that only guides down a relatively small amount, a big 20% haircut. If the PEG was used to value the stock lower and push the price higher on the way up in EPS growth it has to work the otherway around on the way down.

So we see that for growth stocks the Annual EPS Growth estimates are critical to what the current price of the stock is. It is literally a multiplier in calculating the current Price of the stock. As such it makes growth stocks highly subject to wide changes in price due to relative small changes in outlook.

Be careful.
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