Fixing Value

The Price Earnings (PE) ratio and Price/Earnings to Growth (PEG) ratio are commonly used tools for determining the value the market has placed on a stock.

The PE ratio is a common measure of the relative value of a stock based on its Earnings Per Share (EPS). Breaking it down mathematically, PE denotes the amount that you are willing to pay for one rupee worth of the company's earnings. A stock with a high PE ratio suggests that the firm has strong future earnings growth prospects. But investors perceive a low PE as a bargain buy because it may well indicate that the stock price has not risen to reflect the earnings potential of the company.

On the other hand, the PEG is an improvised and sophisticated version of the PE ratio. The reason the PEG is more favoured over the PE ratio is because it also accounts for growth.

The PEG ratio quantifies the relative trade-off between the price of a stock, the EPS and the company's expected future growth. By doing so, the PEG ratio determines whether the market valuation is supported by the predicted future earnings growth rates.

Just like the PE ratio, a lower PEG ratio hints at a better investment opportunity than a higher one. In other words, a cheaper PEG (of two stocks in the same industry) is more favourable than an expensive one. An expensive PEG means that the price of the stock is probably too high relative to the estimated future growth in earnings. As a rule of thumb, a PEG of more than 1 is considered expensive. Let's say a stock has a PE of 25 times earnings. It appears high, but not if you take into account a projected earnings growth of, say, 30 per cent. Its PEG would be a low 0.83 (25 divided by 30). The lower the number, the less you pay for each unit of future earnings growth. So even a stock with a high PE, but high projected earning growth, may be a good value buy.

At the same time, alow PE would not necessarily mean a good bargain but just an indication of graver issues.

A stock may have a low PE but have very low or no projected earnings growth. In such a situation, the high PEG may not offer value. Let's say the PE is 8 and earnings growth is projected to be flat. That would mean a high PEG of 8, a very expensive investment.

Ultimately, PEG is about year-to-year earnings growth. But since it relies on projections, it may not always be accurate.