# Investing: Back to the future

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Updated: May 15, 2015 12:59:34 PM

## While PEG ratio is a useful tool for stock selection, a study of past performance will be in order

Most of us are quite familiar with the term price-to-earnings ratio, or what is popularly known as P/E ratio. But an equally important, though not well-cited, ratio among the investor community is the price-earnings-to-growth (PEG) ratio. Let’s examine how the PEG ratio can be used effectively in the stock selection process.

Why not PE alone?

Let’s start with the P/E ratio, which essentially indicates how much an investor is willing to pay for each rupee of earnings made by the company. If a company, say ABC, has its share trading at a P/E ratio of 30 times, it shows that investors are willing to pay 30 times its annual earnings. In general, we can compare similar shares in the same industry to check whether the P/E ratio of ABC is relatively higher or lower than peers.

But shares with higher growth generally tend to trade at a higher P/E ratio than those with lower future growth opportunities. This is  because the price that investors pay for a share today is not for the past performance alone, but also for its future value. Thus, to assess whether a share’s P/E ratio represents a valuable investing opportunity or not, we need to compare it with the company’s future growth prospects.

What is PEG?

PEG ratio is defined as P/E ratio divided by the company’s annual growth rate. But how do you estimate the growth rate? But in the current context of companies with transparent updates, investors can reasonably discern the growth rate or can use the earnings guidance provided by the company in its annual report. Let us compute the PEG ratio for three company shares. Suppose, ABC company’s P/E ratio is 72.3 with an expected growth rate of 77% per year.

Company BCD’s P/E ratio is 11.04 with an expected growth rate of 35% annually and company CDE’s P/E ratio is 166 with a growth rate expectation of 30% annually. So, the PEG ratio of all the three companies are 0.94, 0.32 and 5.53, respectively.

Inferences

The P/E ratio of any company that’s fairly priced will equal its growth rate. Accordingly, if the PEG ratio is 1, it is fairly valued. If it is below 1, it is undervalued, and if the number is above 1, it is overvalued. So, ABC’s share is fairly valued, BCD is greatly undervalued and CDE is greatly overvalued. Though you would like to simple-screen and pick shares with low PEG ratios, there are a few limitations of this method:

Low annual earnings will skew data: For instance, if the company is expected to go from making R0.01 per year to R0.10 over 5 years as it moves up from its infancy stages, the 900% growth rate over 5 years is 180% per annum. Although the annual earnings growth is exceptionally high, the absolute earnings increase of R0.09 is not nearly as significant as a company that went from making R1 to R10 a share. Beware of wrongly favouring petty shares by seeking too low a PEG ratio.

Earnings forecasts the key: Will a company always meet the expectations stated in the annual report? Though it’s impossible to be sure of that, one can take cue from past earning growth rates. Remember, past growth does not mean that future growth is imminent; however, it will tell you if the company has historical evidence to prove its ability to grow at a fast pace. An unreliable forecast means the PEG ratio should be taken with a pinch of salt.

Do due diligence

Often, you would find uniform analyst forecasts. If there has been a lack of earnings surprises, this means their estimates are accurate. Low dispersion of estimates and low analyst error will increase your probability of having a highly rated stock hitting its goal. Suppose, analyst coverage is non-existent for the share that you are following, you can look at the company guidance for future earnings expectations, assuming that the company has a history of providing accurate and dependable guidance. However, you need to do your own due diligence.

To conclude, PEG ratio is an inordinate tool to quickly scan for good shares at a fair value. You should never choose companies based on a single tool alone.

For instance, other qualitative aspects, such as revenue generation model, business sustainability in the long run, the company’s past performance and its competitive position in its industry, should be considered. If used wisely, the PEG is a great tool that can assist you in finding great shares and a fairly valued price.

What is p/e ratio?

* It indicates how much an investor is willing to pay for each rupee of earnings made by the company
* If a company’s stock is trading at a P/E ratio of 30 times, it shows the investor is willing to pay 30 times its annual earnings
* Stock with higher growth generally tend to trade at a higher P/E ratio than those with less future
growth opportunities

What is PEG ratio?
* It is defined as P/E ratio divided by the company’s annual growth rate
* If PEG is 1, the stock is fairly valued. Below 1, it is undervalued. If the number is above 1, it is overvalued
* If used wisely, PEG can help you spot great shares at fair value

The writer is associate professor of finance and accounting, IIM, Shillong