The role of PEG Ratio to uncover Value Stocks
An investor chooses various types of investment approaches to make money. But there are mainly two types of approach i.e. Growth and value. Growth investors look for those companies that offer strong earnings growth. But value investors look for the company which is undervalued in the marketplace. These two styles of investing don’t contradict each other, rather than add diversity to a portfolio.
Indian stock market offers some good numbers of growth and value stocks. Investors who are attracted to companies which offer growth are always aware about higher upside potential and high risk associated with them. But there’s no guarantee a company’s investment in growth stocks will successfully lead to profit. More so, these stocks experience stock price swings in greater magnitude, so they may be best suited for risk-tolerant investors with a longer time horizon. But most of the investors lack that much risk appetite and capital. So, they prefer value investing.
Role of PEG in value investing
Value Investing is all about finding diamonds in coal mines. It helps in selecting stocks whose traded price is lower than their intrinsic value. It is one of the few tactics which legendary investor Warren Buffet used to pick stocks. One of the key attributes that attract investors toward value investing is simplicity. With the help of financial ratio, one can easily identify value stocks. The most important metrics to choose the value stock is Price to equity ratio.
Before knowing in detail about it, let’s first know about the Price to Equity ratio.
- Price to equity ratio = Price per share/ Earning per share.
It is one of the simplest tools to evaluate the stock of a company. It helps to understand how cheap or expensive a stock is. A lower price to equity ratio is cheap and a buying opportunity. Such stocks are called undervalued stocks. A higher PE means that the investor is paying more for each unit of income, indicating that the stock is over expensive or overvalued. But sometimes it leads to wrong assessment and conclusion as it completely ignores the company’s growth rate. There are hundreds of companies which grow at different rates in their life cycles. During the start timing, growth rates tend to be high compared to the matured phase. But if an investor only chooses the Price to equity ratio, while ignoring the growth phase, then the companies which grow slowly would seem more attractive. On the contrary, the high-growth companies on the other hand would appear expensive due to higher PE multiples. So, a high growth company is a better pick. In order to avoid such distortions in the PE ratio, Peter Lynch developed the concept of price to earnings growth ratio (PEG). It basically compares a stock’s PE to its earnings per share (EPS) growth rate. For example, if company A and company B are trading at 10x earnings. Company A is growing at 5 percent but the other at 9 percent. So, one can easily identify that company B is a better bargain with a higher probability of making you a higher return. So, PEG ratio can be calculated as:
- PEG = PE/EPS Growth rate
The stocks whose price to earnings growth ratio is more than 1 are considered as overvalued stocks, while any stock with ratio less than 1 is undervalued.
In case, if the PEG ratio is equal to 1, then it implies that the stock is fairly valued. But the best stocks are those whose PEG value is less than 0.5. The stocks which PEG value in the range between 0.5 to 1 is fairly acceptable.
Points to note for:
- The ratio has certain constraints, it cannot be applied to companies reporting losses as their PEs can’t be computed.
- In case, if the PEG ratio is calculated using project earnings, then the ratio will be inaccurate if the projections or estimates are not realised.
- More so, the ratio is not applicable to real estate and airline stocks, as their values are based upon their asset values.
- The PEG ratio is also highly susceptible to errors, especially in case of fast-growing companies. For example, a company having a growth rate of 25% per year is unlikely to sustain growth in future. So, one need makes assumptions in companies which the growth rates are speculative.
*Disclaimer: investment in securities market are subject to market risks, read all the related documents carefully before investing