Weighing price against earnings | Value Research The PE and PEG ratios, if used properly, are powerful tools for evaluating whether a stock deserves your investment

Weighing price against earnings

The PE and PEG ratios, if used properly, are powerful tools for evaluating whether a stock deserves your investment

Should I invest in this stock? Finding an answer to this question is what keeps investors occupied round the year. To answer it, a host of quantitative and qualitative parameters may be considered. Two that most savvy investors employ are the PE and PEG ratios. Here is a detailed look at both these ratios and how they can help you choose a stock.

PE Ratio
The Price to Earnings (PE) ratio is among the most frequently used metrics. In essence, it is the company's current stock price divided by its earnings per share (EPS). In other words, the PE ratio tells you how much you are paying for every rupee of the company's earnings.

In the above equation, the numerator is the current price of a single share. But depending on what the annual earnings per share (denominator) is, you can have two types of PE ratios.

Historical PE: When in the denominator you use the preceding 12 months' earnings per share, the PE ratio that you get is the historical PE. The advantage of using historical PE is that both the numerator and the denominator are actual figures (and not estimates). So you are on solid ground when you use this figure.

If you don't have the data or don't wish to do the calculation yourself, you can look up the PE ratio of every listed company on the Value Research website.

Forward PE: A stock's valuation, however, depends not just on its past performance but also (in fact, more so) on its prospects. Hence, analysts also use a figure called the forward PE. Here, while the numerator employed is the current price of the stock, the denominator used is an analyst's estimate of what the EPS will be one year down the line. The disadvantage of this number, of course, is that it is based on an estimate, and that estimate may or may not turn out to be right.

Now, why is the PE ratio important? A high PE ratio indicates that the market has very high growth expectations from the company and has hence priced its stock expensively. A lower PE, on the other hand, signifies that the market has a poor opinion of the company's growth prospects.

There is no blanket strategy for success in the market. If you invest blindly in low PE stocks, you may find that many of them do indeed have poor prospects and hence deserve their low valuations.

Investing in high PE stocks is not a sure-fire road to riches either. If you invest in a very high PE stock and a couple of years down the line its earnings growth falters, you will rue the day you paid such a high price for it.

If you are a value investor, do compare a company's current PE ratio with its own historic PE ratios. That will give you a sense of whether the stock is trading below or above its past valuation levels. Also compare the PE ratio of the stock with that of its industry peers. This too will give you a sense of whether the stock is currently priced high or low.

Some of the factors that have a bearing on PE ratio are:

Growth prospects: Better growth prospects usually lead to investors valuing a company highly, thereby leading to a high PE.

Risk: Higher the perceived risk in a stock, the less the inclination to invest in it, leading to a lower PE.

Past record: A company with a good historical performance is trusted by investors and is hence assigned a higher PE by them.

Economic environment: In favourable economic conditions companies tend to have a higher PE ratio. In depressed economic conditions, on the other hand, the entire market's PE tends to be low.

All other things remaining constant, investors should avoid investing in stocks with very high PE ratios.

PEG Ratio
The PE ratio tells you how much you are paying vis-a-vis the stock's earnings. But this is not sufficient. One also needs to get a sense of whether the valuation of the stock is high or low vis-a-vis its growth prospects. The Price Earnings to Growth (PEG) ratio enables you to evaluate this.

The PEG compares the company's PE ratio with the growth rate in its earnings (EPS). Here again you could calculate historical PEG (historical PE divided by the compounded annual growth rate in earnings over the last three or five years) or forward PEG (forward PE divided by the expected growth rate in earnings over the next one year).

A PEG ratio of one means that the company's stock price is in line with its anticipated earnings growth rate, i.e., it is correctly valued. A PEG ratio of more than one implies that the stock is expensively priced. A PEG lower than one, on the other hand, indicates that the stock is undervalued - and so, a value investment.

As an investor, your job is to look for discrepancies in the market. Through superior research, you should attempt to dig out stocks that have a low PE ratio currently but have high growth prospects.

When PEG doesn't work
Larger, more mature companies will tend to have a high PEG ratio. A mature company wouldn't have a high earnings growth rate, but it would be stable and would generate a lot of cash, resulting in high dividend income for investors. The PEG ratio would not help you discover such stocks. For this reason, the PE and PEG ratio alone shouldn't be your criteria for selecting stocks. Undertake a comprehensive study of a stock before deciding to invest in it.

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