A Close Cousin Of The P/E Ratio

Equitymaster , Last updated: 05 September 2009  

Learning about stock market investing is a never-ending quest. There are several metrics that an investor can look at while selecting stocks. In this article, we discuss one of the many parameters that could help in making better investment decisions – Price-earnings to growth ratio (PEG ratio).

It can be called a cousin of the price-to-earnings (P/E) ratio which is perhaps the most popular yardstick used to value stocks globally. The PEG ratio is also another method used to evaluate the attractiveness of a stock. It is calculated by dividing a company's P/E ratio by its expected growth rate.

In his book 'One up on Wall Street', the star manager of the Fidelity Magellan Fund, Peter Lynch says, "In a fully and fairly valued situation, a growth stock's price-to-earnings ratio should equal the percentage of the growth rate of its company's earnings per share".

It therefore follows that a P/E ratio should be more or less equal to a company's earnings growth rate over the long term. It is rightly said that valuing a stock purely on the basis of historical earnings is not the right way. And given that the process of investing must be done on a forward-looking basis, the PEG ratio adequately factors this into its analysis.

Let us take up an example. Company XYZ is expected to grow its earnings by around 15% to 20% in FY10. The company’s stock is currently trading at a P/E ratio of 22 times its trailing twelve month earnings. On dividing 22 (P/E ratio) by 20 (assumed growth in earnings), the ratio is slightly above 1. This may mean that the stock is fairly valued. On the other hand, if a P/E of a company is 10 and if the expected growth rate in earnings is 15%, the resultant PEG of 0.67 could mean that the stock is attractively valued. Thus, the greater the PEG ratio than a value of 1, the more expensive the stock and vice versa.

However, one must also take into account the industry in which the company operates. For example, the capital goods industry is a high growth industry with strong visibility in earnings over the medium term. It should also be noted that the top-tier companies from any industry may trade at a premium to the overall market.

One of the biggest drawbacks of PEG is with respect to the surety of the growth in earnings in the long-term. What if the expected earnings growth does not materialise? Also, one cannot use PEG for all sectors. Take the case of the steel sector. The industry is cyclical in nature. In times of a downturn, the P/E ratio gets inflated due to lower earnings. As a result, the PEG ratio may not accurately reflect as to whether the investment is attractive or not, particularly if the markets expect the company's earnings to remain subdued, going forward. Similarly, in an upturn, the P/E ratio tends to be lower due to considerably higher earnings and accordingly, the PEG ratio may seem lower and the stock attractive despite the fact that earnings may be headed downwards.

Therefore, it must be understood that the PEG ratio is a good way of comparing stocks in similar or growth-oriented industries, rather than across industries. Also, using only the PEG ratio or the P/E ratio would not be appropriate while evaluating an investment opportunity. One must also look at other ratios, such as return on equity, return on assets, interest coverage, price-to-sales, price-to-book, free cash flows, dividend-paying record and operating margins in order to get a more holistic view of the company.

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