Using price earning growth as an important investment tool
Mohammad Nasir Uddin Chowdhury
MODERN economists frequently note that the capital market is the mirror of the economy. Economy is a vast concept: it consists of what not. Business, Politics, weather, international relations, terrorism etc. all these are the elements of the modern economy. All these factors must contribute towards the movement of the stock market index and this Index is all the performance indicator of the listed companies.
As we know, the stock market is always about discounting the future. So in the case of pricing of stocks, future growth of the companies should be evaluated properly. Macro- and micro-factors should be equally considered in case of evaluation the future growth of a company.
Normally as the common practices, investors apply the price earnings ratio (P/E ratio) to determine whether a company is over- or under-valued. There are, however, many extreme cases of stocks trading at 50 or more times their earnings, even though market price is increasing.
So big question is: why does this happen? It can happen because of company's potential growth in the future. To consider company's growth in the case of stock pricing, modern fund managers use "Price earning Growth" as new investment tools.
It is worthwhile to examine how price/earnings to growth or peg ratio works. The PEG is a ratio to determine a stock's value while taking into account earnings growth. The calculation is as follows: [PEG Ratio=(Price or Earnings Ratio/Annual EPS Growth)].
PEG is a broadly used as an indicator of a stock's potential value. It is favoured by many over the price/earnings ratio (P/E ratio) because it also accounts for growth. It has to be kept in mind that the numbers used are projected and, therefore, can be less accurate. Moreover future projected growth is calculated on the basis of lots of assumptions and local and global polices. For certain changes, figures may vary.
The PEG (price/earnings to growth) ratio is the apparatus that can help investors to find undervalued stocks. It is not similar to P/E and P/B ratios, but it is just as valuable. When used in combination with other ratios, it gives investors a perception of how the market views a stock's growth potential in relation to the EPS growth.
The companies with a high P/E ratio are typically start-up companies with little or no revenues; however, a high P/E does not necessarily mean the stock is not good buy for the long term.
Let us take a closer look at the P/E ratio that tells us about the situation about earnings per share of a company in relation to its market [value per share. Thus, P/E Ratio= (Market Value per share/Earnings per share (EPS))]
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. After all, earnings represent profits, for what every business strives. Earnings are calculated by taking the hard figures into account: revenue, cost of goods sold, salaries, rent, etc. These are all important to the livelihood of a company. If the company is not using its resources effectively, it will not have positive earnings, and problems will eventually arise.
Besides earnings, there are other factors that influence the value of a stock. These include, among other things, the following, for examples: Brand -- The name of a product or company has value. Brands such as Tata, Lafarge is worth billions; Human Resources -- Now more than ever, a company's employees and their expertise are thought to add value to the company; Expectations -- The stock market is forward looking. One buys a stock because of high expectations for strong profits, not because of past achievements; Sponsors- Sponsor aptitude, experience, knowledge, past record, and image has significant contribution towards the growth of the company; and, moreover, international policy and politics, local government policy, investment climate and exchange rate, purchasing power, macro economic indicators have etc., do have mentionable influences on matters for gauging the future growth of any company.
All these factors will affect a company's growth rate. The P/E ratio does not reflect any of these, and it only looks at the past. The relationship between the price/earnings ratio and earnings growth tells as a much more complete story than the P/E on its own.
[The PEG ratio is formulated as: P/E Ratio = (PEG Ratio/Annual EPS Growth)]
PEG numbers can be interpreted as followed. Its ratio compares a stock's price/earnings (P/E) ratio to its expected EPS growth rate. If the PEG ratio is equal to one, it means that the market is pricing the stock in a manner that fully reflects the stock's EPS growth. This is "normal" in theory because, in a rational and efficient market, the P/E is supposed to reflect a stock's future earnings growth.
If the PEG ratio is greater than one, it indicates that the stock is possibly overvalued, or, that the market expects future EPS growth to be greater than what is currently the general investors have calculated. Growth stocks typically have a PEG ratio greater than one because investors are willing to pay more for a stock that is expected to grow rapidly.
If the PEG ratio is less than one, it is a sign of a possibly undervalued stock, or, that the market does not expect the company to achieve the earnings growth that is expected by the investors. Potential stocks usually have a PEG ratio less than one because the expectations about the stock's earnings expectations, have risen and the market has not yet recognised the growth potential.
It is important to note that the PEG ratio cannot be used in isolation. As with all financial ratios, investors using the PEG ratios must also use additional information to get a clear perspective of the investment potential of a company. Investors must understand the company's operating trend, fundamentals and how the expected EPS growth rate reflects all relevant economic indicators. Additionally, to determine whether the stock is overvalued or undervalued, investors must analyse the company's P/E and PEG ratios in relation to its peer group and the overall market.
To illustrate this point, we will use "X" company here as a brief example. "X" is currently trading at Tk. 75 per share and the general investors estimate for this year's (2005) EPS will be Tk. 6.0. This earnings forecast represents 50% growth from the previous year's (2004) EPS of 4.0. The current P/E, on the 2005 estimated EPS, is 12.5 (75 divided by 6). This results in a PEG ratio of 0.25 (12.5 divided by 50).
Now a days, many prudent investors have abandoned the P/E ratio, not because it is worthless, but because they desire more information about a stock's potential. So it is clear that to make investment decision, the P/E doesn't tell us everything. We need to know the growth potentiality. Using the P/E along with current growth rates produces the more informative investment tools i.e. PEG ratio.
The writer is Chief Executive Officer of LankaBangla Securities Limited