PEGging value

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We've been hearing a lot about "stretched valuations" since the market started climbing. From first principles, asset price reflects the future cash flows expected from that asset. Valuation ratios are usually snapshots, offering incomplete information. For example, a PE ratio says nothing about changes in future earnings rates.

The Price-Earnings-growth or PEG ratio is one attempt to introduce the concept of change. It's crude but useful since it integrates information pertaining to change. The concept is not watertight mathematically. If growth is negative, the ratio becomes meaningless.

PEG is derived by dividing PE with the earnings growth (G) rate expressed in a percentage. A stock is considered fair value if the PEG is at 1, undervalued if the PEG is less than 1 and overvalued if PEG is greater than 1. Obviously PE will drop if the denominator (EPS) grows but the extent of drop is dependent on the specific numbers.

However, assuming positive growth, PEG seems to work; PEGs lower than 1 are usually sustainable and a low PEG stock often sees a climb over the long term. It's a better tool for judging gross over/under valuations than a "pure" balance-sheet ratio.

If we use PEG across the universe of Nifty stocks, the market is just moving from a phase of fair valuation into overvaluation. At a PE of 15 in April 2005, it was well below a PEG of 1. In practice, the Nifty universe delivered better than 20 per cent EPS growth across 2005-06 and indeed, projections in April 2005 were accurate in suggesting the market was undervalued.

At an average PE of 20.8 in April 2006, the Nifty is hovering near the PEG cutoff of 1. On the basis of 2006-07 projections, the Nifty universe would see EPS growth in the range of 20-22 per cent in the current fiscal. There isn't a margin of safety, unlike a year ago. And, given cyclical factors such as up-trending interest rates, there is more chance of growth projections going wrong.

We get interesting results using PEG as a benchmark for the IT majors. Currently, Infosys has a trailing PE of 36, TCS has a PE of 33 and Wipro has a PE of 42. In 2005-06 Wipro delivered EPS growth at about 27 per cent, TCS has delivered EPS growth at 50 per cent before the bonus issue, and Infosys EPS grew 32 per cent, pre-bonus. On that basis, only TCS makes the cut in PEG but part of the TCS growth was inorganic and based on the merger with Tata Infotech.

In terms of projections, next year will see 30-35 per cent organic topline growth with all three companies appearing confident about maintaining or increasing margins. Infosys' very optimistic guidance suggests that the EPS could almost double in 2006-07 and the company has never really missed its guidance numbers. On the basis of projections, TCS appears to be fair-value and Wipro is mildly over-valued.

The last factor is the volatility of the rupee, which could make a significant difference to reported EPS for all three currency-sensitive businesses. If the rupee drops, they're undervalued. If the rupee gains, they're overvalued. My take: the rising price of crude should force the rupee down, regardless of the possibility of full float or FII inflows. Hence, the big three are undervalued "" especially Infosys. And, they could make a fairly decent defensive hedge.