Indian stock markets are touching their lifetime highs every day and the question in the minds of most investors is whether the shares are over-valued.
One of the simplest ways to find out if a company’s share is over or undervalued is to look at its price-to-earnings ratio (P/E) and compare it with the industry P/E. If the P/E of the company is greater than that of the overall industry P/E, the share is relatively over valued and vice-versa. Let us suppose that company A is growing much faster than the industry average. Then obviously it should have a higher ratio.
Dealing with growth component
In order to deal with the growth component, one should use the Price/Earnings to Growth or PEG ratio. To understand PEG ratio better, one needs to know the limitations of P/E ratio. The major limitation of P/E ratio is its static nature of analysis, which means that it just looks at the valuation at one point of time similar to that of a snapshot of the company and the industry at a particular point of time. What P/E ratio fails to recognise is the growth rate of the firms within the industry and across industries. In simple words, how much each firm will earn next year compared with what it earned during the current year.
Relevance of PEG
The Price/Earnings to Growth ratio permits us to determine the value of a share, similar to that of P/E ratio, while also considering the firm’s earnings growth. This
forward-looking aspect provides a complete picture of a company’s fundamentals. PEG ratio is computed by taking P/E anddividing it by projected earnings growth (PEG = Price to Earnings Ratio / Projected Earnings Growth).
For instance, a share with a P/E of 10 and projected earnings growth next year of 5% would have a PEG ratio of 2 (the P/E of 10 divided by the projected earnings growth percentage of 5 is equal to 2). The lower the PEG ratio, the more a stock may be undervalued relative to its earnings projections. Contrary, the higher the number, the more likely the market overvalued the stock.
How to use PEG?
A share with a very high P/E might be seen as overvalued and not a good choice. But, if you compute the PEG ratio, assuming it has good growth estimates, it could actually yield a lower number, indicating that the share is a good buy.
The opposite also holds true. If you have a share with a very low P/E, you may assume that it is undervalued. But, if the company does not have earnings growth projected to increase substantially, you may get a PEG ratio that is high, indicating that you should skip this share.
As we all know, the quality of results changes according to the input data. A PEG ratio may be less accurate, if calculated with historical growth rates compared to when the ratio is calculated based on the company’s projected higher future growth rates.
To conclude, PEG ratio could give you a more informed view of a share’s potential once you know how to use and interpret its results correctly.
The writer is professor of finance and accounting, IIM Tiruchirappalli