Nifty trailing Price Earnings (PE) ratio at 27 times is indicating stretched valuations. Also, most stocks are quoting at high PE ratios. Despite this, markets have continued to rise, causing worry and possibly the fear of missing out in the minds of investors. As a rule, investors should invest in reasonably valued companies relative to their growth and not worry about overall market indicators.
• A good approach is to invest in stocks that quote at attractive Price Earnings Growth (PEG) ratio. This ratio is computed by dividing current PE ratio by Earnings Per Share (EPS) growth in the trailing 12 months period. Generally, stocks that quote at PEG ratio of 1 or less are considered attractive. For example, a company which has PE of 30 and is expected to grow at 30 percent, its PEG will be 1. Larger and proven companies like Dabur and HUL can command much higher PEG ratios, and smaller companies and those with erratic past earning records can have very low PEG.
• Best way to assess valuation attractiveness is to examine historic valuation multiples commanded by the company relative to its past prevailing growth rates. Let’s take an example. The chart shows the historic valuation ratios and EPS growth for Asian Paints on past quarter result dates. The PE ratio is very high at almost 90 times and can worry investors. Its PEG ratio is low since March 2021 making it attractive relative to its PEG ratios in past quarter periods. Notice also that the share price has increased sharply since March 2021, contributed by its strong EPS growth.
• PEG ratio helps investors focus on high growth companies and hence is a better measure than PE ratios which can be misleading to investors. Should the market rise, high growth companies will reward better and if the market corrects, it will prevent serious losses.
• An investor should evaluate a company once every quarter at the time of its result announcement. Invest in companies which offer strong growth and sell companies whose earnings are slowing down by using the PEG measure. A strong EPS growth will sharply reduce the PEG ratio and is a good trigger for entry into the stock.
• In addition to examining the PEG ratio, it is important to evaluate if the current growth trend will sustain over the next few quarters. This will give an assessment of forward PEG ratio, which is a more useful measure than trailing PEG ratio. If the forward growth is likely to be strong, forward PEG will be attractive. Forward growth can be judged from management /analyst commentary. This will be the focus of our next article.
Badri Narayanan
badri@equitylevers.com
Equity investor and Founder, Equitylevers Finance Lab