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    Date:5th Febraury 2009

Compiled by Mr. M. Sathya Kumar  

 

 

Uncovering Price-Earnings Ratio & PEG (Price Earnings to Growth) Ratio

Understanding the P/E Ratio

P/E is short for the ratio of a company's share price to its per-share earnings. As the name implies, to calculate the P/E, you simply take the current stock price of a company and divide by its earnings per share (EPS).

A valuation ratio of a company's current share price compared to its per-share earnings is calculated as: -

=     Market value per share
Earnings per share

The P/E ratio is the market's assessment of a company's future prospects. Although very simple to calculate, it is one with gargantuan implications.

Components of P/E Ratio

There are two primary components here, the market value (price) of the stock and the earnings of the company. Earnings are very important to consider. Earnings represent profits for what every business strives. Earnings are calculated by taking the hard figures into account: revenue cost of goods sold (COGS), salaries, rent, etc. These are all important to the livelihood of a company. If the company isn't using its resources effectively, it will not have positive earnings, and problems will eventually arise.

Calculation of P/E Ratio

Most of the time, the P/E is calculated using EPS from the last four quarters. This is also known as the trailing P/E. However, occasionally the EPS figure comes from estimated earnings expected over the next four quarters. This is known as the leading or projected P/E. A third variation that is also sometimes seen uses the EPS of the past two quarters and estimates of the next two quarters.

There isn't a huge difference between these variations. But it is important to realize that, in the first calculation, we are using actual historical data. The other two calculations are based on analyst estimates that are not always perfect or precise.

Companies that aren't profitable, and consequently have a negative EPS, pose a challenge when it comes to calculating their P/E. Opinions vary on how to deal with this. Some say there is a negative P/E; others give a P/E of 0, while most just say that the P/E doesn't exist.

Historically, the average P/E ratio in the market has been around 12-30. This fluctuates significantly depending on economic conditions at the time. The P/E can also vary widely between different companies and industries.

Using the P/E Ratio

The P/E ratio for a growth stock should equal the growth rate of earnings.

This implies: -

If the P/E Ratio < EPS Growth Rate:
A stock is under priced.

If the P/E Ratio = EPS Growth Rate:
A stock is fairly priced.

If the P/E Ratio > EPS Growth Rate:
A stock is overpriced.

This is because earnings provide the fuel for growth. To some degree, a company's stock will rise and fall based on reported earnings and changes in forecast future earnings. The stock price, then, is determined by how quickly earnings grow, and how earnings are expected to grow in the future.

Unfortunately, future earnings and future growth rates are not known with any certainty. They are available only as forecasts or estimated earnings. That makes pricing the stock problematic.

Substantial evidence supports the view that the market takes a sophisticated approach to assessing accounting earnings. This evidence can be grouped into 3 classes: -

  • Evidence that accounting earnings are not very well correlated with share prices

  • Evidence that earnings window-dressing doesn't improve share prices

  • Evidence that the market evaluates management decisions based on their expected long-term cash flow impact, and not on their short-term earnings impact

    Empirical Proof of Low Correlation Between Accounting Earnings and Share Prices

    According to the accounting model, a strong correlation should exist between EPS growth and shareholder returns. However, a study shows that there is hardly any correlation with Pearson's Coefficient being as low as 0.17.

    The study included the companies under BSE-100 Index. Average EPS growth was calculated by considering the data for the past 4 years (2000-2004). When similar study was conducted in US capital markets, the Pearson's Coefficient was 0.088.

    In many ways, the venerable P/E ratio is a blunt instrument. All it tells you is that one stock is selling for 10 times its earnings per share, and another is selling for 30 times earnings. And yet the two companies could be in completely different industries, and could also be at completely different stages of development. Should they be valued in the same way? Most analysts would argue that they shouldn't.

    We can compare the P/E of each stock to the average multiple in their respective industries, and in fact one should, since that might help give one a sense of their relative value. But one may still be dealing with two very different companies at completely different stages of evolution,

    In a way, the idea of the PEG ratio is to compare the earnings of a company to itself, that is, to compare the P/E of a stock to the company's internal growth rate, with fair value in the range of a one-to-one ratio. In other words, if a particular company can only manage to increase its earnings at 10 per cent per year, then its stock is arguably only worth 10 times earnings; if a company can produce growth of closer to 30 per cent per year, then its shares arguably deserve to trade at close to 30 times earnings.

    Moving on to PEG (Price Earnings to Growth) Ratio

    PEG is a widely used indicator of a stock's potential value. It is favored by many over the price/earnings ratio because it also accounts for growth. The usual ratios of earnings, reve to price doesn't tell if a company is "expensive" or really a future growth company. The PEG ratio can perhaps tell something more about if a company is just "expensive" or really has a bright future of growth and expansion.

    Thus, relationship between the price/earnings ratio and earnings growth tells a much more complete story than the P/E on its own. This is called the PEG Ratio and is formulated as: -

    PEG Ratio = Price Earnings Ratio / Annual EPS Growth

    Here's how to put the ratio to work. Say Infosys is trading at a forward P/E of 35 times earnings. After making the comparison and discovering that rivals Satyam and Patni Computers are both trading at multiples around 20, one might begin to think Infosys looks awfully expensive

    But then you look at earnings growth. First, we see that Infosys earnings are expected to grow at 40% annually over the next three to five years, while analysts are predicting Satyam will grow at 15% and Patni Computers at 20%. That would give Infosys a PEG of 0.88, while Satyam weighs in at 1.33 and Patni computers at 1. Looked at in that light, Infosys doesn't seem so pricey after all

    Generally, we use a forward P/E in the PEG ratio, but a low PEG using a trailing P/E is even more convincing. Anything below 1 is of interest, although there really are no rules of thumb. Like the P/E, different industries regularly trade at different PEGs. It's also true that the PEG works less well for large-cap companies that by nature grow at a slower rate despite strong prospects. As always, the key is to compare a company to its peers.

    The PEG ratio's weakness is that it relies heavily on earnings estimates. In 1998, for instance, some companies in the oil-services sector routinely had projected earnings growth rates in the 35% range. But by the end of the year, the crash in oil prices had them swimming in losses. Had one been impressed by their bargain-basement PEG ratios, one has lost a lot of money.

    These risks aside, however, the PEG ratio is another useful tool for an investor to have besides P/E ratio, like the instruments lined up as the surgeon prepares to operate.

    Article by Varun Dawar,Professor in a reputed management institute

    and a  one-size-fits-all P/E ratio comparison isn't going to help that much. That's where the PEG comes in.

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