It is common practice for investors to use the Price-Earnings ratio (P/E ratio) to determine if a company is over or undervalued. There are, however, many extreme cases of shares trading at 100’s and 1000’s times their earnings, affecting the ratio’s accuracy for assessing a company. Companies with a high P/E ratio are typically startup companies with little or no revenues or with huge expectations; however, a high P/E does not necessarily mean the share isn’t a good buy for the long term.
P/E ratio is the share’s market price divided the share’s EPS (earnings per share). Earnings are calculated by dividing the company’s profit after taxes by the total number of equity shares issued by the company. Besides earnings, there are other factors that affect the value of a share like, brands, human capital, expectations (markets are forward looking and you buy a share because of high expectations for strong profits, not because of past achievements) etc. All these factors will affect a company’s growth rate. The P/E ratio does not reflect any of these, and only looks at the past.
The relationship between the price/earnings ratio and earnings growth tells a much more complete story than the P/E on its own. This is called the PEG (Price Earnings to Growth) ratio and is calculated by dividing the company’s P/E ratio by its annual EPS growth. The number used for annual growth rate may vary and it can be forward (predicted growth) or trailing (past growth), and between a 1 to 5 year time span. Looking at the value of PEG of companies is just like looking at the P/E ratio: a lower PEG means that the share is more undervalued.
Let me demonstrate the PEG ratio with an example: You are interested in buying shares in one of two companies. The first is a software company with 50% annual growth in profits and a P/E Ratio of 100. The second company is in the consumer products business. It has lower earnings growth at 24% and its P/E ratio is also relatively low at 12.
Many justify the share valuations of software companies by relying on the assumption that these companies have enormous growth potential. Can we do the same in our example?
P/E ratio (100) divided by the annual earnings growth rate (50) = PEG ratio of 2
Consumer Products company:
P/E ratio (12) divided by the annual earnings growth rate (24) = PEG ratio of 0.5
The PEG ratio shows us the sexier software company, compared to the consumer products company, doesn’t have the growth rate to justify its higher P/E.
Investors are getting more selective. Many have abandoned the P/E ratio, not because it is worthless, but because we desire more information about a share’s potential. We’ve realized that the P/E doesn’t tell us everything we need to know. Using the P/E along with current growth rates produces the more informative PEG ratio, a far better indicator of a share’s potential value.
Milan is a veteran stock market investor and educator on equity investing. Connect with him on firstname.lastname@example.org