The price-to-earnings (P/E) ratio is one of the widely used and accepted metrics for stock valuation. It is generally assumed that stocks with high P/E are overvalued, whereas low P/E stocks are undervalued. However, like many other financial metrics, the P/E ratio also has some limitations. Since this ratio is calculated based on the current price of the stock over its last one year of earnings, it does not take into consideration the company's future growth rate, which is a major drawback of this metric.
Given this drawback, legendary investor Peter Lynch popularised the price-earnings-to-growth (PEG) ratio and mentioned this in his famous book One Up On Wall Street. As interpreted by Lynch, "The P/E ratio of any company that's fairly priced will equal its growth rate." The PEG ratio is calculated by dividing the company's P/E ratio by its earnings growth in the specified period. A PEG ratio of less than one implies that the company's stock is undervalued and more than one is overvalued.
Let us understand it with an example. Both Company A and Company B trade at a P/E of 15 but Company A has delivered earnings growth of 20 per cent in the past as against 10 per cent by Company B. Thus, in this case, the PEG ratio for Company A and B will stand at 0.75 and 1.5 times, respectively. This implies that Company A is undervalued as compared to Company B, irrespective of the same P/E ratio. This interpretation of the PEG ratio provides investors with more insights into a stock's fundamentals, which the P/E ratio alone cannot provide.
The PEG ratio helps us better interpret a company's stock valuation. A stock with a very high P/E may look overvalued and may not look to be a good choice. But given that the company has a good growth expectation, the PEG ratio may indicate that the stock can be a good buy.
In view of this, we have checked the companies that are trading at the PEG ratio of less than one and at the same time, are fundamentally strong. As the PEG ratio factors in the company's future growth, we have filtered out companies that delivered high growth in the past.
- Market cap of more than Rs 1,000 crore
- PEG ratio between 0 to 1
- Five-year revenue and EPS growth of more than 10 per cent and 15 per cent, respectively
- Current and five-year average ROE of more than 15 per cent
- Debt to equity less than one
- Positive free cash flows in the last three years
Like many other metrics, the PEG ratio also has its own set of limitations. One of the most difficult tasks is to assume a company's future growth, which can highly affect the value of this ratio and limit its accuracy. The following table lists companies based on the above-mentioned filters and could be a good investment option. However, one should research thoroughly before investing in these companies.