PE ratio, that is the Price/Earnings ratio is a common valuation number used by investors in stocks. The PE number gives an idea as to whether the stock is under-valued or over-valued.

It is defined as:  PE ratio = Market price of the share /  Earnings per share (EPS)

However, the problem with PE ratio is that it is a meaningless number, by itself. Is PE of five good or bad? Or should it be 10? Or possibly say 25? Mathematically speaking, the lower a PE stock appears, it's considered better than a higher PE stock. But is it really so?

Why do we buy a stock? We buy it so that when its price goes up, we canl sell it and make profit. But why should the price of the share go up? Again simple, the price would go up if the company makes higher profits ie. higher earnings per share (There are, of course, many other reasons for share prices to go up, but from the fundamental perspective, the price of a share is ultimately a reflection of it’s profits).

In other words, it is the growth in the earnings, which gets reflected in the share price. And since we are buying a share in anticipation that it’s price will go up in future, we must look at the expected growth rate of its earnings, especially over the next two-three years.

Comparing the two ie. the PE ratio and the EPS growth of a company gives a more meaningful picture. PEG ratio or the Price Earning Growth Ratio is defined as:  PEG ratio = PE ratio / EPS growth rate

PEG ratio=1; This means that the share price is fully reflecting the company’s future growth potential ie. the share at today’s prices is fairly valued.

PEG ratio>1; This indicates that the share price is higher than the expected growth in the company’s profits ie. the share is possibly over-valued.

PEG ratio<1; This indicates that the share price is lower than the expected growth in the company’s profits ie. the share is possibly under-valued.

Therefore, the PEG ratio tells us something more about the future potential of the company. It tells us whether the high PE is a superficial number or is supported by future growth prospects.

Let us look at an example to get a better perspective. We have an information technology (IT) company whose PE ratio is 30 and expected EPS growth rate of 40%. And then, we have a banking stock, with PE ratio of 12 and EPS growth rate of 8%.

On the face of it, if we only look at the PE ratio, the banking stock looks cheaper and attractive. But what about the PEG ratio? Let's do the simple math:

IT company PEG = 30/40 = 0.75

Bank PEG = 16/8 = 1.50

Going by the definition of PEG ratio, we find that the IT company’s share is undervalued considering its future growth prospects. And so its share price is likely to appreciate more than the bank stock.

However, as usual, there is a word of caution. Like any other financial number, the PEG ratio is not a law, but a very useful indicator of a whether a share price is under or over-valued. It cannot be looked at in isolation. One must:

a) Look at other numbers such as P/B value, operating margins, return on equity etc.

b) Compare it with the peer group

c) Consider other non-financial factors too, such as brand value, management quality, barriers to entry etc.

This is so because we are only estimating the EPS growth. If our expectations of growth do not materialise, the share prices can fall. Or sometimes the market gives more value to things like brands. This is so because, even if the growth rate does not justify a high price, the brand value acts as protection. Say there is a fall in the demand, then it is likely that large reputed companies will be less affected, than relatively unknown companies. There is a sort of stability of returns expected.

Therefore, to get the best out of this PEG Ratio, it may be prudent to follow investment guru Peter Lynch’s advice – first, find the companies whose long term prospects look good and have good management quality and then check whether their share price is under-valued using the PEG Ratio.

The author, Sanjay Matai, is an investment advisor and can be reached at sanjay.matai@moneycontrol.com

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