In our blog post, Importance of EPS in equity investing, we discussed how Earnings per Share (EPS) and share price of a company appreciation are related. Companies whose earnings grow faster also see higher appreciation in their share prices. Investors want capital appreciation and therefore like to see high EPS growth. But to buy high EPS growth, you will have to pay a higher price because demand for such stocks will obviously be more. You may not mind to pay a higher price, as long as you expect to get higher returns, but at the same time, if you have to pay a very high price, then your capital appreciation potential becomes limited. So at what price should you buy stocks? The answer to this question is a vast and complicated topic. Let us first discuss the most basic valuation measure of a stock, Price / Earnings ratio and then we will discuss the relationship of Price / Earnings ratio with EPS growth.
Price /Earnings ratio (abbreviated as P/E ratio), as many of our readers know, is the most popular valuation ratio for stocks. For benefit of all readers, P/E ratio (Price / Earnings) is the ratio of the share price and EPS of a company. There are two variations of P/E ratio:-
If the P/E ratio of a stock is high, it is usually considered “expensive”; if P/E ratio of a stock is low, it is considered “cheap”. Readers should note that the terms “expensive” and “cheap” are not straightforward as far as equity investment decisions are concerned. In our day to day lives, we prefer to buy items that are cheap (unless it is a luxury purchase), provided of course, we have quality assurance. Simple logic dictates that you should buy cheap stocks (low P/E ratio) and sell expensive ones (high P/E ratio). But in stock markets, a high P/E ratio stock is not necessarily considered unattractive.
If you follow the stock market you will see that, share prices of some companies grow much faster than others. Without looking at the companies financials, you may think that, companies whose share price grew very fast also gave high earnings (EPS) growth. Your thinking is most likely to be absolutely correct; companies whose share prices grow rapidly, usually, are the ones which deliver high EPS growth. But then, if you look at the companies financials, you may see that the share price (in percentage terms) may have grown faster than the earnings.
When the share price grows faster than the earnings, the P/E ratio goes up.You may expect the stock to take a breather so that the earnings catch up with the share price increase, but in reality you are likely to see the stock price appreciating even further and the P/E ratio increasing. You should understand that stock prices are a function of demand and supply. If the stock price is going up, it implies that, investors want to buy the stock despite the higher price (P/E ratio).
Why would investors want to buy an “expensive” (please note that the quotes denote that the term expensive is quite subjective) stock? As discussed at the start of this post, as an investor, you want capital appreciation. A stock which gives high EPS growth is likely to give high capital appreciation as well. On the contrary, you will see that, many share prices of many companies with low P/E and relatively less EPS growth remain subdued for a fairly long time. Therefore, investors may not mind buying a so called “expensive” stock instead of a so called “cheap stock”. But is there a price beyond which you should not be willing to pay, even for a high EPS growth stock?
Based on what we have discussed so far, P/E ratio alone cannot determine the investment attractiveness of a stock. You have to look at P/E ratio relative to the EPS growth. There is a valuation measure, which determines a stock’s value while taking the company’s EPS growth into consideration. This valuation measure is known as Price / Earnings to Growth or simply the PEG ratio. But before we discuss what PEG ratio is, let us spend a little time looking at different investment styles because, as mentioned at the beginning of this post, valuation is complex topic and there are multiple viewpoints depending on investment styles and objectives.
“Price / Earnings to Growth” is the topic of our post and yet we are discussing this concept towards the end of this post. I spent more time in this post, explaining the context in which PEG should be used be used in stock selection because as PEG is fairly simple to understand as a concept if you know about P/E and EPS, but the context in which PEG should be used is more important. Let us now understand briefly what PEG is.
PEG, very simply, is the stock’s P/E ratio divided by the forecasted earnings (EPS) growth. Since PEG factors in both P/E ratio and earnings growth, it can tell you whether a stock is over-valued or under-valued given its earnings performance. A stock with lower PEG is a more attractive investment than a stock with higher PEG. You can use historical (trailing twelve months) earnings growth to calculate PEG, but using forward earnings growth is always more beneficial.
Let us take two companies, A and B. Following are the assumptions:-
Let us now calculate P/E and PEG
You can see that, Company B is “cheaper” than Company A in terms of P/E ratio. Purely from a P/E standpoint, Company B seems to be more attractive. But in terms of PEG (GARP perspective), Company A is more attractive than Company B.
In this post, we have discussed valuation with respect to earnings growth and the importance of PEG. Though as a mutual fund investor, you do not have to do stock selection yourself, it may be informative to understand what strategies, fund managers of your mutual fund schemes use in stock selection. Armed with superior knowledge of equity investing, you can get a better understanding of how the fund manager’s style and strategy may affect your investment performance in the short, medium and long term.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.
Mirae Asset Global Investments is the leading independent asset management firm in Asia. With our unique culture of entrepreneurship, enthusiasm and innovation, we employ our expertise in emerging markets to provide exceptional investments opportunities for our clients.
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