Master Class 11: Price to Growth (PEG) Ratio

4 Sep 2020  Read 370 Views

One of the most important steps in evaluating a company's financial health and position is its valuation. Basically, the valuation of anything is an estimation of its worth. 

The valuation of a company can be done by the valuation of its assets. It is a quantitative process that determines the accurate value of a firm or its assets. It is important to remember that a valuation result cannot be determined with just one method, technique, or absolute value. Valuation is done through a number of methods and techniques. 

Calculation and analysis of valuation ratios is a common and basic method of a company valuation.

This article talks about the various important factors and valuation ratios that are required for analyzing a company's financial health and its investment prospects. 

We will learn about the simple concepts of PEG ratio and its evaluation in case of Indian stocks, and how these valuation ratios influence our choice as a potential investor. 

PEG - Price Earnings to Growth Ratio

The Price Earnings to Growth ratio or PEG ratio is one of the valuation ratios that help in the company's valuation. It helps identify if the stocks are overvalued, undervalued, or fair-valued. 

As we have already seen, the Price per Earnings ratio, or popularly called the PE ratio, is the Price that the buyer pays for every rupee earned by the company.

By the same concept,  Price Earnings to Growth ratio (PEG) is the ratio of P/E against the growth rate of the company's profits or profit growth rate.

Calculating the PEG Ratio

According to its name, the PE in PEG ratio stands for the P/E ratio, and G stands for the profit growth. The Price Earnings to Growth ratio of a company is the ratio of its P/E ratio and its profit growth rate.

PEG ratio = Price per Earnings ratio (P/E ratio) / Profit growth rate over the years

It suggests that the Price to Earnings ratio of a company should not be more than its profit growth rate.

Since mathematically, PEG ratio = PE ratio / Profit Growth over the years. PE should preferably be less than or equal to the Profit growth over the years. This means that the Price Earnings to Growth ratio should preferably be 1 or slightly around 1.

PEG ratio of 1 or around shows that the company is fairly valued. If the PEG ratio is less than 1, it is an undervalued stock and if it exceeds 1 then it it is overvalued.

The Profit growth rate should be considered for a period of three to five years, ideally. This length of the period covers a relatively longer time frame for a company.

It is important to remember here that the PEG ratio does not give the final verdict about any stock, and any decision should not be made based solely on the PEG.

The same goes for all valuation methods. Each valuation method acts only as an indicator and not as a sole decisive factor.

PEG ratio is a fair valuation technique for companies that have a stable income. This is common for sectors like FMCG and Pharmaceuticals and even some IT companies, where earnings grow regularly.

To understand this more clearly with real-life examples of companies listed in the Indian stock market, you can refer to this video tutorial: YouTube.

Have you read our previous Master ClassReturn on Capital Employed and Return on Equity - ROCE Vs ROE ?

Period of profit growth rate for PEG ratio

One question that stays is what should be the period of years while considering the PEG ratio of Indian stocks? In a situation. one must always look at the company's recent trends. 

If the past 1 year's growth rate is more consistent with the growth in the last 3 years, consider the Profit growth rate for three years. On the contrary, if the company has performed consistently similar over five years, then the 5 year period should be considered.

In simple words, one should ideally consider the time period that is more consistent with the recent trend, say the past one year. If neither three nor the five year period trends match the recent trend, this ratio will not help because it is useful in cases of companies that have a 'stable' income growth.

For situations like these, where you need the availability of such important data of companies across industries, Finology ticker is the 'go-to' platform within just a scroll.

Price to Cash Flow Ratio

The Price to Cash flow ratio is a type of valuation ratio that gives a basic indication of the value of a company's stocks.

Cash flow is the amount a company actually receives for its sale of goods or services. The profit that a company shows is based on its sales and not on the actual cash earned; hence it doesn't necessarily mean that the company has received the actual payment for all its services.

The P/E or Price per share against the Earning per share is about the profit that the company makes. The Price to Cash flow ratio indicates the Price per share against the actual payments or cash received by the company.

Ideally, the P/E ratio should match the Price to Cash Flow ratio. Yet, a high Price to Cash flow ratio as compared to a lower P/E suggests that the company has been unable to realize the payments it should receive against the services/products it has sold.

A company's EPS shows the earnings per share of the company based on profit. Yet, the Price to cash flow expresses the amount you are getting as actual earnings. So if the Price to cash flow ratio is 10, it means you are paying 10 times the cash flow of the company. 

Just like other valuation ratios, the P/CF ratio is also just an indicator. One may always choose to look at the products the company produces or the services it provides. On the basis of this, one may decide if they want to go ahead and buy the stocks by paying 11 times the cash flow, or maybe 12 times the cash flow of a different company if its products are better and present a better prospect.

Conclusion

Both the PEG ratio and the Price to cash flow ratios are valuation ratios that give a basic idea of a company's valuation. These ratios give an idea of the valuation of a company's stocks and help determine if they are undervalued, overvalued, or fairly valued. 

These ratios give an insight into a company's stock valuation and help in the process of determining whether a company's stocks are worth buying or not. However, it is important to remember that both the PEG as well as the P/CF ratios give just an idea and should not be the sole decision-making factors. They should always be combined with other valuation tools in order to make a complete, well-informed valuation of a company and then make the investment decision.

Ceckout the next Master Class: Understanding Quick Ratio & Interest Coverage Ratio

To read all Master Class series: Click Here 

About the Author: Anuja Khandelwal | 18 Post(s)

Anuja Khandelwal is a finance content writer at Finology. With a bachelor’s degree in Management and a master’s in mass communication and journalism, Anuja started writing blogs as a hobby, which later turned into passion. Together, with her passion for writing and interest in Finance, she wishes to create unique infotainment through her words.

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