Know the difference between PEG & P/E ratio
Source:Economic Times Big Bucks
The price-earnings growth ratio is a variant of the price-earnings ratio. The information contained in PEG ratio is not very different from what can be derived from a properly calculated P/E ratio. As a retail investor you are unlikely to calculate this yourself, but if you can, you will benefit from the insights. PEG ratio's utility lies in that it urges you to look forward. It is also somewhat easier to interpret than the plain-vanilla P/E ratio. In mathematical terms, it is calculated by dividing current P/E ratio by expected earnings growth.
For example, let’s try calculating it for Infosys. The current P/E of Infosys on consolidated 12 month trailing profits is 32 times. To calculate PEG, we need to formulate growth expectations. For the moment, let’s take a cue from the numbers put out in broking reports. The expectation for a 12-month earnings growth is around 28%. This gives a PEG of 1.14 (32 divided by 28). The growth expectation over the next two years in broking reports is similar, so the two-year PEG is also 1.14. Let’s take a look at L&T now. Its current P/E ratio is 38 times. Net profit can be expected to grow at a rate of 45% for next 12 months. This makes the PEG around 0.84. Mphasis BFL currently quotes at a P/E of around 18 times. It is expected to grow around 25%. This makes a PEG of 0.72. Notice the numbers.
They are around 1, either a little more or somewhat less. The number 1 is in a way a neutral rate for the PEG ratio. At this number, the P/E and earnings growth rate are perfectly matched. If the PEG ratio is less than one, it means that earnings are growing faster than the P/E. In other words, the P/E will fall next year if the price doesn't change. If the PEG is more than one, it implies that earnings are growing slower than the P/E. This means P/E will increase in future if the price remains the same. The latter points to an unpleasant scenario. Increasing P/E means the stock is becoming more expensive. So holding on to a stock with a PEG greater than one is dangerous. Should you continue to hold a stock with a PEG greater than 1? Ideally no, unless you are short of better ideas.
You may well ask at this stage - 'Why doesn't a stock correct so that its PEG becomes lower than one?' There could be various reasons. There may be other players in the market with a higher view of earnings growth of that company. Sometimes, markets give premium for management quality. Funds will hold companies like Infosys till it gets really expensive, with a PEG of say 1.4 or more. Some investors use the thumbrule of buying at PEG of around 1 or less for large companies and 0.5 or less for mid and small caps. So, L&T, at a PEG of 0.84, is still a very good buy. Infosys looks expensive. Mphasis BFL looks okay too.
