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PEG ratio: A perspective...

Mar 2, 2006

How to go about investing in stock markets is a never-ending quest. And since there are no right or wrong ways to go about things, it becomes even more perplexing. Here is one of the valuation parameters, which an investor could make use of while making investment decisions in equities.Well, one ratio that can be used to evaluate the attractiveness of a stock is the price-earnings to growth ratio, known as PEG. Its cousin, the price-to-earnings (P/E) ratio, is already well known, being the most popular yardstick used to value stocks globally. In simple terms, the PEG ratio is the ratio of a company's P/E ratio to its expected growth rate. Peter Lynch, the star manager of the Fidelity Magellan Fund, in his book, 'One up on Wall Street', put it like this: "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 the 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.

To take an example, Infosys, the 'technology bellwether', is expected to grow its earnings by around 33% to 34% in FY06. If we take the trailing 12-month earnings of the company, the stock trades at 34.8 times. Thus, the ratio is slightly higher than 1. This may mean that the stock is fairly valued. However, one must also take into account the industry in which the company operates. For example, the software industry is a high growth industry, with strong visibility in earnings over the next three years. Thus, it is only fair that the top-tier companies from the industry should trade at a premium to the overall market.

Another factor to ponder over is the time horizon that an investor has. If the investor wants to hold the stock for a period of 2 years, then the PEG ratio would be much lower than 1. For Infosys, if we assume a 30% CAGR in profits till FY08, the P/E ratio, at the current market price, works out to 19.3 times. This translates into a PEG of 0.64 (19.3/30), which undoubtedly appears attractive. Thus, the longer the investment horizon, greater is the likelihood that the PEG ratio will be more attractive, particularly in a growth industry like software.

However, 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 if the markets expect the company to maintain strong earnings momentum.

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. All said and done, at these all-time high levels, one must continue to invest with a stock-specific approach and we suggest not committing the mistake of upgrading valuations (i.e. paying higher price) just because the stock market is bullish.

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