Lensing through price/earnings to growth ratio (PEG)

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Australian Economy, Macro Economics

When evaluating stocks with value and growth, one factor that takes the front foot is Price/earnings to growth ratio, which is also called the PEG ratio and is generally defined as stock’s price-to-earnings (P/E) ratio divided by growth rate of earnings for a particular time period.

Consider we have two companies – Freelancer Ltd. (ASX: FLN) and Dorsavi Ltd. (ASX: DVL). The first, Company FLN, trades at $0.455 per share (as at May 09, 2018) and has -$0.011 in per share earnings with conservatively estimated loss of 40.79% in the last 6 months. The second Company DVL, trades at $0.125 per share, has -$0.028 in per share earnings and has conservatively estimated loss of 59% in the last one year. Which stock looks to be a cheaper one? Using the PEG ratio, we can answer this question. One would simply plug in the numbers to the PEG ratio formula and derive the PEG ratio for a hint on valuation of the companies.

Coming to banking sector scenario, an instance that has seen bank valuations push towards their cheaper in years based on one year forward price multiples can be considered. Even after paying dividends, over the past 12 months, the major banks’ stocks have generated losses pushing 7 per cent in the case of CBA and Westpac, and 4 per cent for ANZ and NAB, as per Bloomberg data. Over the same period the ASX 200 benchmark equity index has generated total returns of 10 per cent. Going back by about three years, the underperformance is even more stark as the market generated close to 25 per cent against NAB’s roughly 10 per cent total return and 5 per cent or so from the other three. Now, PEG ratio can help identify the growth prospects in such cases.

Thus, if you are looking for investments with value and growth, this is the ratio to look at. The PEG or price-earnings to growth ratio is a valuation ratio used along with the P/E ratio, in stock analysis. It calculates the price of a stock in relation to the earnings per share, and the projected growth of the company. The PEG ratio is calculated as:

PEG ratio = Price to Earnings ratio/ Annual EPS growth

An investor can use the PEG ratio to determine if a stock is overvalued or underpriced. One can use the PEG ratio as a reference as follows – PEG ratio above 1 indicates that the stock is overvalued, and company’s future earnings are not going to grow much and the stock may undergo a correction in price.; PEG ratio of 1 demonstrates that the stock is fairly valued given the expected growth rate; and PEG ratio of less than 1 means the stock is undervalued as the markets are currently underestimating growth while negative PEG ratio could be the case where the current earnings are negative, or the future earnings are going to decline.

Drilling this down to an example: 2 companies A and B having a P/E ratio of say 10 and 40, with earnings growth being projected at 2% and 45% respectively, will yield PEG ratio of 5 for company A and 0.88 for company B. We see that even though company B has a high PE ratio of 40, considering the PEG ratio it is undervalued and can make a case for good growth potential. Of course, this needs to be looked at along with many other factors to evaluate the actual potential with support from pipeline of projects, other developments and/or technological updates.


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