The price-earnings to growth ratio is a good indicator to judge a company's future potential.
Financial ratios are important tools for identifying stocks. Last week, we covered the price-earnings (P/E) ratio. This week, we will look at the price-earnings/growth (PEG) ratio. Like the P/E ratio, the PEG ratio can also be utilised to get a good perspective of whether a company's stock is fairly priced, overpriced, or underpriced.
The PEG ratio actually attempts to determine a stock's value, along with the earnings growth. The formula for calculating this ratio is, PEG ratio = price-earnings ratio/ annual EPS (earnings per share) growth.
The PEG ratio uses the P/E ratio of a company and compares it with that of a company's annual growth rate. If a company's stock is fairly priced, then the P/E ratio should equal to its annual growth rate.
Let's take an example:
Price of stock ABC= Rs 3,000
EPS = 150, P/E ratio = 20 (3,000/150)
However, this company is expected to grow by 20 per cent annually, which means its expected annual EPS growth is 20. In this case, stock ABC will have a PEG of 20/20 = 1
If the PEG ratio of a stock is 1, then this stock is said to be fairly valued. This means that the market is pricing the stock to fully reflect its annual EPS growth rate.
Of course, this is a logical explanation and everyone would like to believe that all markets are rational and efficient, in nature. So, the EPS growth should, ideally, be reflected in prices. However, stock markets are far from being efficient and most of the times, stocks are either overvalued or undervalued.
If the PEG ratio of a stock is less than 1, it means that this stock is underpriced or undervalued. But it could also mean that the market expects the EPS growth to be much lower than it has been projected.
Similarly, if the PEG ratio is more than 1, it means that the stock could be overpriced. But the catch is that the market could be expecting it to better its EPS growth rate thereby, taking the ratio closer to 1 and making it fairly-valued.
Growth stocks like ICICI Bank or Punj Lloyd typically tend to have a higher PEG ratio because investors are generally willing to pay for a stock that is growing quickly. At the same time, even a Hero Honda has a high PEG ratio. What is important here is to know the projected growth in EPS for each of these companies. It's the investors perception of a stocks' earnings growth that determines it valuations and hence the PEG ratio.
Investors do take the stock market cliché of “stock prices are slaves of earnings” seriously. As a result, sometimes even though earnings forecasts have been lowered, prices do remain stable for a variety of reasons.
At the same time, value stocks tend to have a lower PEG ratio because investors are yet to recognise the potential of the stock. Market conditions often force investors to be concerned about a stocks' future earnings growth.
| PEG STOCKS IN BSE-100 | |||
| TOP FIVE | 3 -YR CAGR | ||
| LATEST P/E RATIO | EPS GROWTH | PEG | |
| ICICI Bank | 17.57 | 1.91 | 9.22 |
| Hero Honda Motor | 15.37 | 2.88 | 5.33 |
| Punj Lloyd | 31.25 | 6.14 | 5.09 |
| Adani Enterprise | 44.22 | 14.40 | 3.07 |
| Bharat Forge | 21.37 | 7.66 | 2.79 |
| BOTTOM FIVE | |||
| Financial Tech. | 6.12 | 218.17 | 0.03 |
| Sesa Goa | 6.07 | 64.15 | 0.09 |
| Bank of India | 5.88 | 58.46 | 0.10 |
| Union Bank (I) | 4.87 | 43.33 | 0.11 |
| ACC | 7.98 | 65.30 | 0.12 |
For instance, the bank stocks - though most analysts are convinced about the potential of banking stocks in this country, the current interest rate scenario has battered most banking stocks to a level where they are screaming value. As the table reflects, Bank of India and Sesa Goa can be termed as undervalued stocks, with a lot of promise.
Like the PE Ratio, a PEG ratio should never be utilised as the sole indicator for identifying gems. It should be one of the indicators besides the fundamentals, technical chart of the stock and other parameters. Once you have calculated or found out the PEG ratio of the stock you wish to buy, take a look at the PEG ratios of similar companies in the same sector. For example, in the telecom industry, most stocks (high growth) are likely to exhibit a higher PEG ratio. So, if some company doesn't exhibit a higher number, one needs to delve into details.
Yes, PEG is supposed to arm you better in the hunt for the stock that suits your portfolio and risk appetite. But, it is important that you do not use just one or two parameters. Instead, go through the whole exercise of looking at different parameters before coming to any conclusion.
The writer is director, My Financial Advisor
