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PE and PEG Ratio
It is a good time for investors to go bargain hunting. The current market is ripe with stocks available for less than their actual worth. If bought at current levels, many of these are likely to provide excellent returns in next 2 to 3 years as they provide a significant room for an upside.
The decline should be considered as an opportunity for long-term portfolio construction rather than a time to stay away from the markets.
The hunt for value usually drives investors to focus purely on the price to earnings (PE) multiple of a particular stock. This popular measure provides a snapshot of a stock's value; a high PE usually implies that a stock is overvalued, while a lower PE could mean that it is undervalued. Considering the PE ratio is a good starting point, but it is not without its limitations.
It is, at best, a lagging indicator, which takes into account only the past earnings, not the future growth. As such, a low PE may give the impression that the stock is undervalued, but if the company's earnings are not growing, its value is also not likely to rise.
The premise for using this ratio is rooted in the understanding that the growth rate of a stock that is valued correctly would be almost equal to its PE ratio. In other words, the PEG ratio of a fairly valued stock would ideally be equal to one.
When the PEG is equal to one, it means that the market has correctly factored in the expected earnings growth. A PEG ratio of less than one would mean that the market has not adequately priced in higher growth expectations and that the stock is, therefore, undervalued. A PEG ratio higher than one implies that the market is paying much more for the stock than is justified by its earnings growth. So, the lower the PEG of a stock, the better it is.
Of course, the PEG ratio is not a foolproof indicator of value. Since it is a forward looking measure, one has to rely on analysts' projections of future earnings, which may not always be accurate. The PEG ratio relies heavily on surety of growth in earnings in the long term. If the expected earnings don't materialise, the PEG ratio will fail to provide the true picture."
Predicting the earnings for companies with erratic cash flows is more difficult. For instance, one would have to be cautious while taking the PEG ratio of cyclical companies at face value, believes that the PEG ratio is a more appropriate valuation tool for growth stocks.
"For a high-growth company, the PE that the market assigns to a stock may seem to be high as it does not incorporate the high growth potential of the company." Also, earnings growth is just one part of the story. Other parameters like cash flow, dividend payouts, operating margins, etc, are also key considerations. Investors should ideally avoid using a single tool to study stocks that are potentially undervalued.
Having said this, the PEG ratio gives a holistic picture about the stock price relative to the company's growth expectations. It can be effectively used with other tools to arrive at a list of value stocks worth considering. We have incorporated this in our study to identify stocks that could be bargains at their current valuations, given their robust fundamentals.
Similarly, a high PE could make a stock's valuation seem stretched, but what if the company's earnings are likely to keep growing rapidly? In such cases, using the PE ratio would not be a good idea. So what is a good measure of a stock's value?
A tool often ignored is the PEG (price to earnings growth) metric. It is essentially an enhanced version of the PE ratio, which combines value with growth. The PEG ratio is calculated by dividing the stock's PE ratio by its expected 12-month earnings growth rate (PEG ratio = price to earnings ratio/ earnings per share growth).
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(updated - 01 Oct 2011)