PEG ratio of Indian stocks proved to be a precise value indicator for the investors of our country.
PEG is a ratio between ‘Price to Earning Ratio (PE)’ and ‘EPS growth rate’.
Most investors are conversant with the use and utility of PE ratio. In fact, it is one of the most used ratio having utility in stock valuation.
To quickly check, if the current market price of stock is correctly priced or not, investors use PE ratio. Dividing current market price with EPS gives PE ratio.
The ease with which one can calculate PE ratio; and its relationship with current price and companies net profits, makes it so popular among investors.
But over a period of time, investors realized that PE ratio alone does not give a totally correct picture of stock valuation.
General concept is, a stock which is trading at PE ratio of 15 is better priced than a stock with PE ratio of 20.
This is not always right. It is possible that a stock having higher PE ratio be better valued than a stock having lower PE ratio. How?
This is where the utility of PEG ratio comes into picture. We will see in detail about PEG ratio in this article.
These days, experts use a combination of PE and PEG ratio to estimate price valuation of stocks. This combination is more reliable than use of PE alone.
Though PEG ratio cannot estimate the intrinsic value of stocks, but at least it gives a fair idea. PEG ratio gives an idea that if the stock is trading at overvalued or undervalued price levels.
To know the intrinsic value of stock, one need to do a detailed fundamental analysis of the stock. But if somebody does not have so much time, use of PEG ratio is highly recommended.
Even in the detailed fundamental analysis of a stock, which eventually estimates its true value, EPS growth rate is an important indicator. But when we use PE ratio to value stock price, EPS growth rate is not utilized.
But we use EPS growth rate in calculation of PEG. So, indirectly PEG gives a very confident hint about stock’s true value.
Peter Lynch and PEG ratio
It is widely believed that high PE ratio represents overvalued stocks. Rule of thumb says that PE above 15 represents overvalued stocks.
Benjamin Graham who is known as father of value investing liked stocks with P/E < 15. This concept of PE<15 was successfully used by many investors for decades.
But not very long back, Peter Lynch coined another valuation theory known as PEG ratio. Theory of Peter Lynch made the use of standalone use of PE obsolete.
These days investors looks at PE & PEG ratio together.
In this article, with use of real life example, we will see the utility of PEG ratio. In the example, I will provide list of few low PE stocks with its PEG ratio. I will also provide list of few high PE stocks with its PEG ratio.
Such an example will highlight that, even if a stock’s PE ratio is low but if its PEG ratio is high, it is overvalued.
The example will also highlight that, even if a stock’s PE ratio is high but if its PEG ratio is low, it can be deemed as undervalued.
But before we see this list of stocks, I will try to give more insights about PEG ratio.
PEG ratio and intrinsic value of stocks
Stocks are valued in comparison to its intrinsic value. Stock’s intrinsic value is estimated based on its potential to generate future free cash flows.
It is not possible to predict future. But looking at the past, investors can approximately estimate the pattern of future growth.
A company which has shown stable growth in sales, net profit and net worth, their future free cash flow estimation is comparatively easier.
In the process of stock price valuation, net profit of a company is expressed as EPS. The patter of historical EPS movements of a stock has big influence on its intrinsic value calculation.
We are aware that stock’s EPS directly influences its market price. When EPS is growing at fast rate, its market price will also appreciate in same proportion.
Consistent EPS growth rate can take PE ratio of stocks to sky high levels.
PE Ratio Vs. PEG Ratio
Benjamin Graham liked stocks which had PE<15. But does it means that all stocks having PE>15 are bad? This is where Peter Lynch’s theory of PEG becomes handy.
According to Peter Lynch, even when PE ratio is very high, still that stock can be undervalued. Lets take an example. A stock PE ratio is 28 and its EPS growth is 31.
It means PE is lower than EPS growth. In this case PEG will be less than one (0.9).
If PE is less than EPS growth rate (PEG<1), it means the stock is undervalued. Why?
Stocks having PEG<1 has higher potential to increase its EPS (and hence its market price) in time to come.
Suppose a stock X has PE ratio of 20. Another stock Y has PE ratio of 15. Does it mean that Y is better prices as compared to X?
To understand this, lets take a hypothetical example of the two, most traded stocks of Indian stocks market: NTPC and ITC.
Few stock metrics of these two companies are tabulated below:
|Market Price (Rs.)||181||258|
|EPS Growth expected for next 5 years (%)*||7||28|
*EPS growth rate assumed is hypothetical.
As per the general understanding ITC will be considered overvalued because of its PE ratio is higher. PE ratio of ITC is 29.91 compared to 16.91 of NTPC.
Fundamentally both NTPC and ITC are exceptional companies. So if one decides to buy stocks just on basis of PE ratio then they will select NTPC.
But we know that PE ratio alone is not the best yardstick to select stocks. Lets use the PEG ratio factor to understand a more realistic price valuation of NTPC and PE ratio.
Though ITC has higher PE ratio but still it is a better buy. How?
To understand this, we have to analyze stocks using the concept of PEG ratio. ITC has very high PE ratio compared to NTPC, but this high PE ratio is still justified.
A growth stock can afford to have a higher PE ratio, but still be undervalued.
A stock which has faster EPS growth rate can enjoy the luxury of high PE ratio. Consider the case of ITC. It’s PE ratio is massive at 31.22.
Some might ask that why ITC’s PE ratio is so high? By investors are buying ITC stocks at such exorbitant PE levels?
The answer is hidden in possibility of future EPS growth.
NTPC’s and ITC’s EPS grow (EPSG) rate is 7 and 28 respectively.
|EPS Growth expected for next 5 years (%)||7||28|
This makes PEG ratio of ITC 1.06 and that of NTPC is 2.41.
Even though NTPC shows lower PE ratio, but still ITC is better valued.
The lower is the PEG ratio the better the stock is valued. A PEG ratio of less than 1 (one) means there is a reasonable chance that the market price of stock will appreciate considerably in future.
Understanding PEG numbers
What does PEG Ratio of < 1 means?
– The stock is undervalued
– We can expect future growth in market price of stock as its EPS will probably increase in times to come.
What does PEG Ratio of > 1 means?
– The stock is overvalued
– We cannot expect future growth in market price of stock as its EPS will probably decrease in time to come.
Limitations of PEG Ratio
PEG may not be suitable for large companies
Large and established companies, which has reached a point of saturation exhibits lower EPS growth rate.
For such companies PEG ratio will generally be high (above one). Does it mean that such companies are bad investment?
Such large established companies provide decent dividends. They may not ensure a good capital appreciation, but high dividend yield is what makes them a good-buy.
This is one reason why, an investor must look at the size of the company first (net worth or market cap). If the company has large market cap and also exhibit low PEG, this makes it very inviting.
If large market cap company is showing PEG above 1, but has paid decent dividend in past, still makes it interesting for investors.
Watching PEG ratio in parallel to dividend payment consistency and dividend yield is essential.
This is one limitation of PEG, that it talks nothing about the dividend portion of the stock.
Low EPS growth does not always mean the business is bad
There can be condition where due to external factors, EPS growth rate of company may be low.
Low EPS growth rate may result in higher PEG ratio. Like, it is recently happening with real estate and pharma sector in India.
Recent quarter EPS growth rates of quality Pharma stocks like Ajanta Pharma, Lupin etc are in negative. Does this make them a bad stock to invest?
May be in short term Pharma stocks will not provide good returns, but in long run returns will be good.
Here, relying only on PEG ratio is not advisable. Looking at the over all business prospects of a company is necessary.
This is a reason why a detailed stock analysis is necessary. Relying only on few ratios may lead to errors in estimation.
Suppose a company which is fundamentally very sound but due to temporary problem (like government policy) the sector is performing badly.
As because company is fundamentally strong, it is bound to bounce back in times to come.
Even Indian government cannot afford to maintain bad policies for too long.
Recently, Indian government has passed a bill allowing REITs in India. These kind of policy decisions will help the ailing real estate stocks.
All real estate companies stocks are showing negative or high PEG ratio. But with implementation of REITs, this situation can dramatically improve.
Investors must question why a particular stock is having high PE ratio.
Higher PE ratio on its own shows incomplete picture. Investors must also look at fundamentals of company along with PE ratio.
EPS growth rate is that fundamental that helps to estimate true value of stocks.
If a company is able to grow its earnings at a fast pace, then investors will be willing to pay a high price to grab such stocks. This is the logic why even high PE ratio is acceptable at times.
We suggest our readers to look at PE and PEG ratio all together.
In our example we compared NTPC and ITC. Both has two different line of business, but PEG ratio allowed us to compare two companies of completely different sector.
PEG Ratio of Indian Stocks 2018
(Updated on April’2018)
- Reliance Industries Ltd.- 1.3448 PEG (TTM)
- Tata Consultancy Services Ltd.- 1.5361 PEG (TTM)
- HDFC Bank Ltd.-1.3667 PEG (TTM)
- ITC Ltd.-3.1463 PEG (TTM)
- Housing Development Finance Corpn. Ltd.-1.0211 PEG (TTM)
- Hindustan Unilever Ltd.-8.7549 PEG (TTM)
- Maruti Suzuki India Ltd.-1.0645 PEG (TTM)
- Infosys Ltd.-1.3621 PEG (TTM)
- Oil & Natural Gas Corpn. Ltd.- -2.7324 PEG (TTM)
- State Bank of India – -0.75 PEG (TTM)
Check this link to find list of Top 100 Indian stocks with their PEG Ratio in tabulated form…
Disclaimer: All blog posts of getmoneyrich.com are for information only. No blog posts should be considered as an investment advice or as a recommendation. The user must self-analyse all securities before investing in one.