|
PE and PEG ratios
You must be fairly acquainted with the P/E ratio as it is one of the most commonly accepted valuations metric for any stock. Analysts around the world have been using this metric over a period of time to find out the worth of a stock. The entire investment community has been approving of this simple measure of valuation. P/E ratio is simply expressed as Current market price of a share divided by the earnings per share. The recognition that this ratio enjoys highlights the fact that investors believe that it is ultimately the earnings power of a firm that creates value for its shareholders. P/E ratio considers the EPS generated by the firm over the past 12 months.
If the net profit of the firm is Rs. 10 crores and its shares outstanding are 1,00,00,000. Its EPS turns out to be (100000000/10000000)= Rs.10 per share. If the current market price of the share is Rs. 250, the P/E ratio of the stock would be (250/10)= 25.
However, like all other ratios, P/E ratio also has its limitations. One major constraint of this ratio is that one can only compare P/E ratios of the same industry. The measure is inadequate for relative valuation of different industries. The usual procedure involves determining a benchmark P/E for an industry and comparing the firm's P/E ratio to the industry's to interpret the value of a stock. A lower P/E than the industry benchmark P/E may be seen as undervaluation of a stock or market's perception on a company's inability to meet industry expectations in the future. Similarly, a higher P/E stock may be seen as an overvalued stock or belief of the market in the future success of a firm.
Consider two companies A and B belonging to the same industry and with similar growth prospects. P/E ratios for A and B are 25 and 15 respectively. This implies that market believes that firm A is worth paying more for the earnings per share it provides. This could be for a variety of reasons - including quality of management, quality of products and brands and therefore long term sustainability of earnings etc.
But if we want to compare stocks across the industries, which metric do we use? PEG serves as the answer. PEG is an extension of the P/E ratio which enables an investor to compare the value of companies across different industries. It accommodates the earnings growth estimate of the firm along with the past earnings performance of the firm. The relevance of this ratio arrives from the fact that there are several other factors that determine a stock's price rather than only its past earnings performance. The company's future prospects in sync with the industry's growth trajectory are a major factor that attributes a value to a stock.
Now consider two firms X and Y. X is a media company while Y belongs to the power utility industry. The P/E ratio of X is 25 and that of Y is 12. On the outset, one may believe that the media company is more expensive than the power utility company. This is true in isolation. But, does this mean that the power utility company is a better buy than the media company?
Entertainment industry is a fast growing industry while power utilities grow at a much slower rate. In view of the same, analysts may view the anticipated earnings growth rate of the media company as 35% and 10% for the power utility one. Working out PEG for the two companies:
Media company, X:
PEG =(25/35) = 0.71 which is less than one
Power utility, Y:
PEG=(12/10)= 1.2 which is more than one
Contrary to our initial view, Y seems to be a little overvalued and X seems to be undervalued. When we considered only P/E, Y seemed undervalued and cheap. An analyst may recommend the media stock as P/E of 25 is better warranted for media than P/E of 12 for the power utility company. Hence, PEG is a better indicator of the worth of a stock than P/E alone.
A PEG of one would mean that market has priced the company fairly in accordance with its anticipated earnings growth rate. A PEG of less than one usually implies undervaluation. It may also mean that investors are uncertain about the company's ability to meet the growth expectations set by analyst consensus. Similarly, a PEG of greater than one indicates overvaluation or the belief of the market that the company will surpass the growth expectations.
In the past, IT industry in India garnered lot of attention from the investment community. The companies in the industry enjoyed high multiples and valuations. This was on account of high growth rate of the industry which was growing at a pace of 50-70% and not overvaluation or because of market inefficiencies. Since, now the earnings growth has moderated to around 20%, P/E has also settled to around 20.
PEG provides a more complete picture of the value of stock than P/E alone. The future growth of the company is as crucial a factor as its past earnings performance to interpret its true value. However, PEG is more apt for analysing growth stocks. Dividend yield is not accounted for in PEG. For investors desirous of fixed income, dividend yield of a company could be added in the denominator with the earnings growth rate to arrive at a fair multiple for the stock. Another constraint on the accuracy of PEG is the accuracy of the consensus estimates of the growth of earnings itself. Sometimes, an entire industry may be undervalued. With a caution on the aforementioned constraints, PEG can lead to fairly implementable results.
Share your thoughts and perspectives
Do you have any observations or insights or perspectives to share on this issue? Did this help you understand the topic better? Do you disagree with some of the observations? Please post your comments in the box below …… it's YOUR forum !
|
