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
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:-
Trailing Twelve Months (TTM) P/E: Trailing Twelve Months (TTM) P/E is the ratio of the share price divided by the sum of the EPS in the last 4 quarters (12 months). It is easy to calculate the TTM P/E based on current share price and the financial statements of the company.
Forward P/E: Forward P/E is the ratio of the share price divided by the forecasted EPS for the next 12 months. It requires professional expertise to forecast EPS, but forward P/E ratio is a more useful valuation measure because future earnings are more important than past earnings. You can find Forward P/E ratio of stocks in business and financial portals, where they calculate forward P/E using consensus analyst estimates of forward EPS.
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.
Relationship between P/E Ratio and EPS growth
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.
Different investment styles
Growth Investing: These investors look for high growth stocks. In our post, Importance of EPS in equity investing, we had discussed that, stocks which give high EPS growth are likely to see higher capital appreciation relative to others. Growth investors look for stocks which can give superior EPS growth in the near term, say 12 to 24 months. The share prices of these stocks are likely to rise faster than other stocks in the nearer term. Critics of growth investing say that, while growth stocks can give superior returns in the near term, they can also get overheated, especially in a momentum market like India and therefore can suffer sharp corrections in a market downturn.
Value Investing: These investors look for stocks which are trading at a deep discount relative to its fundamental or intrinsic value. Value investors look for low P/E stocks which can ensure adequate Margin of Safety when buying stocks. Margin of Safety not only limits downside losses, it can also get investors extraordinary returns in the future (please read our post, Margin of Safety: Importance in Equity Investing).
The legendary Warren Buffet was one of the pioneers of value investing. He always looked to sufficient Margin of Safety in his stock investments and shunned many high growth stocks in favour of value stocks. However, as a value investor, you need to have a lot of patience to hold your stocks for a very long period of time to get the best returns.
Growth at a Reasonable Price Investing: Growth at a Reasonable Price (abbreviated as GARP) is a blend of growth and value investing strategies. GARP looks for stocks that have high growth potential and yet, are somewhat undervalued relative to other growth stocks. Unlike a value investor, a GARP investor is not looking for “cheap” stocks. Remember, we had discussed earlier that, if you want to buy a high EPS growth stock, you should be prepared to pay a higher price. A GARP investor is prepared to pay a higher price, but not an unreasonably higher price. GARP investors also look for margin of safety, like value investors, but from a different valuation perspective.
One of the most important valuation measures used by GARP investors, which distinguishes them from growth and value investors, is Price / Earnings to Growth or PEG. One of GARP’s main advocates was the legendary fund manager, Peter Lynch. Lynch’s book, “One up on Wall Street”, is written in very simple language, which even a layman investor can understand, yet is a pioneering discourse in GARP, and its fundamental valuation metric, PEG.
Price / Earnings to Growth
“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.
How to calculate PEG?
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.