In this Demystifying Investment series, we simplify and explain some of the standard terms (jargon) that are essential to making sound investment decisions.
Very often, you will hear of investors benefiting from undervalued stocks which eventually gained a lot of momentum. Investors also lose money in an overvalued stock that rolled down in value after its 15 minutes of fame. But there’s more to the terms ‘overvalued’ and ‘undervalued’ than what novice investors may perceive them to be.
Evaluating the value of a listed company’s stock is the first step investors and fund managers follow to shortlist their investment options. And a simple formula they all use to do so is by comparing the company’s price-to-earnings (P/E) ratio and the price/earnings-to-growth (PEG) ratio with its industry group or a benchmark market.
Understanding P/E Ratio & PEG Ratio
What Is P/E Ratio?
The price-to-earnings ratio is a simple evaluation of a company’s current stock price with respect to its net earnings per stock, also termed as earnings-per-share (EPS). The EPS value is derived simply by dividing the current net earnings of the company by its number of outstanding stocks. This value is calculated for a fixed time period, usually 12 months.
What Does it Mean? ➔ A company with a higher stock price but lower earnings per share would yield a higher P/E value, meaning it is overpriced or overvalued. ➔ A company with a similar stock price and higher earnings per share will have a lower P/E value, meaning it is undervalued. ➔ A company whose stock price matches its earnings per share is considered fairly valued.
For example, if a stock has an EPS of $2 over the past year and is currently trading at $10 per share, its current P/E value would be 5 (10/2). A professional analyst would say that this stock is trading at five times earnings.
The P/E ratio helps you determine the intrinsic value of a stock as compared to the company's earnings.
The P/E ratio can be calculated to learn a stock’s historical value as a trailing ratio or its future potential value as a forward ratio.
Limitations of the P/E Ratio
While investors prefer considering a company’s P/E as a judge of its performance, here are a few reasons why it should be used with a pinch of salt:
Sporadic market volatility: A ratio of a volatile market phase easily misrepresents a company’s value in short-term calculations.
Lack of Future Growth Perspective: The P/E ratio neither considers nor indicates a stock’s growth rate, which is essential to the stock evaluation process.
How Does the PEG Ratio Help?
To overcome the shortfalls of the P/E ratio, investors refer to the price/earnings-to-growth (PEG) ratio of a stock. It is calculated as the trailing P/E ratio of a company with respect to the growth rate of its EPS. Invented by the legendary American fund manager Peter Lynch, the PEG value offers a clear factor for an apples-to-apples comparison of stocks in the same industry groups based on their expected growth.
PEG Ratio = P/E ratio of the stock/projected EPS growth rate
What Does it Mean? ➔ A company with a higher P/E ratio and a high EPS growth rate would yield a lower PEG value (typically less than 1), meaning it is undervalued. ➔ A company with a similar P/E ratio and low EPS growth rate will have a higher PEG value (typically more than 1), meaning it is overvalued by the market. ➔ A company with a PEG value equal to 1 is considered to be fairly valued.
A company that is expected to grow its capital but is currently undervalued is always a more lucrative investment than the ones which are overvalued. And this key insight of a company’s intrinsic value is successfully derived by the PEG ratio.
What Investors Must Consider
Here are some key mindsets investors should maintain when interpreting P/E and PEG ratios:
Comparing P/E & PEG Ratios
Fundamentally, a stock with a relatively low P/E or PEG value would be more lucrative. But a stock may have a lower P/E ratio due to a dropping stock price caused by legal troubles or reducing earnings due to management issues. In which case, investing in a higher P/E or PEG valued stock with proven growth potential would be wiser. Therefore, believe only in complete research.
Getting The Estimates
While past earnings cannot always project a stock’s future growth rate, it is a constant value that is reliable. And while the projected future earnings can help you choose the most lucrative stock, it is an estimate that may vary from source to source. So you must ensure that you refer to trusted sources for your estimates or calculate them by yourself.
Investing In The Company
Though Peter Lynch invented the PEG ratio, he himself believes that investors should invest in what they know and companies they believe in. He also suggests that investors must have some tolerance for higher P/E and PEG values if a stock is growing in earnings rapidly.
While the PEG ratio offers a crucial characteristic of market stocks, it isn’t absolute and easily misinterpretable. So you must rely on various ratios and standards to analyze your stocks and markets and invest in your own judgment.
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Also, learn about another such key ratio that investors talk about i.e. the Sharpe ratio used to assess a stock’s risk. And if you haven’t heard it yet, head over to this article on understanding the Sharpe ratio to make risk-adjusted investment decisions.