P/E and PEG ratio – EquityManiac

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In the whole financial world, all the analysts focus on the price value multiples to make a peer-to-peer comparison with different companies and valuation purposes, So let’s have some glance on what are price multiples, how we can derive it

Price Multiples are the multiples that divide, multiply, add or subtract with the value of the current market price. Let me give certain examples like Price to Earnings, Price to Book, Price to Sales, Price to CFO, PEG ratio and many more. We certainly will talk about the most common and most evaluated price multiples is Price to Earnings(P/E) and PEG Ratio.

we will start with the simple and most utilised tool for valuation is P/E ratio. What is the P/E ratio?, how many types of P/E ratios?, how can we calculate P/E ratios?. We will certainly make clear all your questions in few time.

P/E ratio

P/E ratio is also called Earnings Multiples Ratio. P/E ratio= Market Price/Earnings per share or it can simple termed as P/E ratio= Market Capitalization/Earnings. So to simplify let’s take an example. Considering Divis labs. We can get earnings per share(EPS) from the financials in the annual report published by the company at BSE or the company’s website. So current earnings for divis lab for 2019 is 50.96rs per share and share is currently trading at 2327rs per share, so the P/E ratio for divis lab= 2327/50.96=45.66. So what does 45.66 means?. 45.66 means that if the company continues with the same earnings and at the stagnant price we will get back our investment in ~46 years ( excluding Dividends). so why people invest for such a long horizon if they have to wait 46 years to just earn the principal amount and not adding any value to their capital. So after this point, you will not buy the stock as stock is overvalued right!!. Now you are on the correct way, you understand that at this point of time stock is highly overvalued and you will end up at buying a low P/E stock right. Before we move ahead let’s discuss types of P/E

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Trailing P/E and Forward P/E

Trailing P/E is calculated by the Market price/Current years earnings, which we have already seen in the above example of divis lab.

The most populated P/E which is discussed by almost every analyst is Forward P/E. It is the market price/ next 12 months earnings( forecasted). which helps us to identify the business sustainability and can analyse the growth in the business.

Let’s do some Sceanrio Analysis for P/E.

Scenario 1
Scenario 2
Scneario 3

In scenario 1 we can analyse that industry is concentrated and there is very less scope to untap the new resources or there is less focus on innovation and most focus on operations. Let me state an industry like OIl and GAS, this industry is saturated and grow at a stagnant speed, for sake of an example we have taken a growth rate of the company at 5% and P/E multiple of 10. we can see that in the 7th year we are just earning our principal amount. ( Assumption= same earnings, no change in the business model, same growth).

In scenario 2 we can analyse that industry is growing at a growth rate of 25% and assuming the same growth rate with the business model. we can see that due to the high growth rate, the market is giving P/E of 20. So even in this case, we are getting our principal back in the 7th year. So even getting such a high growth rate in our business model we are just earning our principal as same as in scenario 1. Hold your breath let’s jump to scenario 3.

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In Scenario 3 we are assuming a startup model like OYO or Zomato or any startup you like or business like DMart, HUL etc. The startup has an exponential growth in the business or industry as they are the most innovative and leading in the industry, we assume 100% growth rate in our business model and while most of the time market gives a crazy valuation of 100 P/E. So even after giving such high growth in the business model, we analyse that we get our principal amount in the 6th year. So even after such an exponential growth we just get our principal back one year before compared to 1st and 2nd-year Scenario.

Conclusion

I know you will have a counterpoint as you can see after earning the principal i.e 6th and 7th year, what massive earnings the business model give us. In scenario 1 you can see in the 10th year, we are earning 3rs while in Scenario 2 we can see in the 10th year we earn 21rs on our investment and in the 3rd scenario we are earning 1946 from our investments. wow right!!!, The 3rd scenario is called lollipop investing.

Lollipop investing are the investments made on the prediction of future earnings and betting on the present business, even though the current business model has not enough earnings nor the great probability of sustaining. If you want to be a real investor never ever focus or allocate the majority of your portfolio in the Scenario 3 because you don’t have any idea of sustainability of the business, industrial behaviour, market segmentation, core competition etc. when opportunist sees such a growth in this industry, competition comes into the picture and every calculation of your investments turns into blunders and your return on investment falls horribly.

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So having many lags in the P/E ratio. Peter Lynch derived a ratio called PEG ratio which tells us a totally different story of the business. The lower the PEG ratio, the more the stock may be undervalued given its future earnings expectations. Adding a company’s expected growth into the ratio helps to adjust the result for companies that may have a high growth rate and a high P/E ratio.

How to derive PEG ratio?

PEG ratio= Price to Earnings(P/E)/EPS Growth. In our example we can say that for scenario 1 we have a PEG ratio of 2, In Scenario 2 we have a PEG ratio of 0.8, in scenario 3 we have a PEG ratio of 1.

So as per the analysis, we can see that the most attractive investment as on the given scenario is, scenario 2 and yes as an analyst or an individual investor we obviously focus on such an opportunity where we get such a good company at low P/E and PEG ratio.

It is too obvious that we can’t make any investments of the basis of just P/E and PEG ratio we have to consider many more factors than focusing just on this relative valuations but yes it is important to analyse and compare the peer companies and if any company following the same business model with less P/E then yes you can surely bet on the company to achieve a handsome return on the investments.

Thanks For reading,

EquityManiac.

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Pujan Shah
Pujan is a Commerce Graduate from Mumbai and CFA Level-3 candidate. He does Financial Analysis, Financial Modelling, Valuation, Sector Analysis, and loves to read about every aspect related to Finance.
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