## Friday, September 02, 2011

### Stock Valuation Tool: PE and PEG Ratio

Whenever you will read an article on stock screening and valuation, there is a zero per cent chance that you will come across PE ratio and PEG Ratio. If you are wondering that what are PE & PEG ratio and how you can use them to value stocks then probably you have landed in a right page. Here instead of making it complicated for our readers, I will try to explain with example what are these ratios and how effectively you can use them to value shares.

### First calculation of PE Ratio

- Step 1: Open income statement of a company and note its net profit
- Step 2: In the same financial report, note that how many shares are outstanding in the market
- Step 3: Calculate Earnings Per Share (EPS): Net Income/ Number of shares outstanding
- Step 4: Note the current market price of this share
- Step 5: Calculate PE ratio: Market Price / EPS

### Calculation of PEG Ratio

- Step 1: Refer last five years income statement of the company and note each year’s EPS
- Step 2: Calculate the annual growth rate of EPS for last five years
- Step 3: The growth rate calculated in step 2 can be assumed to continue in future.
- Step 4: Calculate PEG Ratio: PE ratio / Growth rate
Use of PEG ratio in stock valuation has become very famous these days. As a rule of thumb if PEG ratio is one or below then we can say that the current PE multiples are justified.

### How to make use of these PE to evaluate stocks?

There is one concept called earning yield. The value of earning yield tells an investor about the profitability of the company at the present market price. I know it is not making sense now, how PE ratio is related to this definition of Earning Yield?

Inverse of PE ratio is earning yield. Suppose a share has PE multiple of 10, inverse of PE will be 0.1 or 10%. So for this share the earning yield if 10%. So what? Let me ask you a simple question, A company ‘X’ has EPS of \$1 in current financial year. In May its price was \$20, in July it price was \$25, you will prefer to buy this share in May or July? I know 100% of you will answer that you will buy in May because it sounds cheaper. The concept of earning yield will give you a better explanation of this stocks being cheaper. In our example the PE ratio in May is 20 and in July is 25. Inverse of PE = PEG = 5% in May and 4% in July. Most of the investors would stop at this stage and prefer to buy the share in May. But take they must take one more step. See what is the prevailing risk-free return (like bank deposits) prevailing in the market. Suppose risk free return is 4.5%. If earning is higher is lower than this risk free return, then it means that there is no point in taking risky by investing in this share, instead you shall buy a bank deposit which will make your money grow faster. For a value investors it very important to buy shares at undervalued price. Use of Earning Yield and comparing it with risk-free rate of return is a great way of valuing stocks for value investors.

As an investor we have a choice of investing in stocks or fixed income options. The choice of investment options available to us are many. But for now let us limit our choices to stocks and fixed income options. Suppose you have \$1,000 as free money for investment. You have two choices either you can put your money in fixed deposit or you can buy shares. In fixed deposit your principal will be safe and on top of that you will earn a nominal interest.

This interest is a reward given to us by banks for saving our money (and not spending). Suppose the interest (reward) given to us by the bank if 4.5% per annum. So in one year time your principal amount \$1,000 will grow to \$1,045. But if you choose share as your investment option, you would like to be rewarded more than just 4.5% (risk free return).

In shares we are taking a risk by investing our money. There is a chance that our principal amount \$1,000 may get eroded instead of appreciating. There is no surety that your \$1,000 will only appreciate (like fixed deposit). Hence when we invest in shares we shall expect a risk premium (risk free rate + risk premium). There is no defined levels of risk premium buy let assume it to be 3% for our understanding. So if I am buying a share worth \$1,0000 then I will expect a minimum return of 7.5% (4.5% + 3%) per annum.

But I know world is not always fair, if investing in shares would have so mathematically perfect then why some people still prefers fixed deposits over shares? The catch here is in stocks valuation. We can expect to earn risk premium only when we are buying the shares at its true value.

Buying an overvalued share will only make loss for us. This is the reason why we uses the logic of comparing risk-free rate with earning yield. If the company stock is expected to grow at a rate faster than the risk free rate (at a good premium) only then we shall decide to buy that share.

### How to make use of these PEG to evaluate stocks?

In our PE/Earning yield discussions we have assumed one thing as constant and that is income/profit growth potential of the company. See, if we say that by investing in share we shall earn at least 7.5% per annum, this will only happen if company (1) continues to make profits & (2) If company growth its profits at a rate not less than 7.5%. Generally when we talk about share we shall not talk about short term. In short term performance of company can be very volatile.

But five to seven years horizons will give a good stable growth (if companies fundamentals are strong). In order to know if the company can grow its earning at a rate of 7.5% per annum in next five years, we will have to take a clue from its past performances. This is where PEG ratio helps us to estimate the future growth prospects of stocks. If PEG ratio is one, then its means than there is good probability that the company’s earnings will continue to grow at the same rate as that of the past. Or in other words we can say that at the present price levels, the PE multiple of share is justified by the level of earnings that company is making.

### Conclusion

One fact that becomes very clear to investors when we discuss PE and PEG is that buying an overvalued stock is foolishness. If your stock is not able to earn you risk premium then there is no point in risking your money in that stock. Earning yield is a reasonable and quick method of stock valuation. Even if the stock is undervalued, but if it has no growth prospects then there is no point in buying that share.

PEG tells us about the growth prospects of the company. I know it is not possible to predict future, but if other parameters remains same, then PEG highlights the trend of growth that a given company is heading for. In short, both PE & PEG ratio are one of the most useful (but not limited to these) stock valuation tools available for investors.
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