The Price Earnings Ratio - PE

The P-E/growth connection - Information on the price-earnings ratio (P-E) to help you buy the right stock.

The price-earnings (P-E) ratio can help gauge the 'value' of a stock. P-E tells us at how many times a company's earnings per share (profits) its stock is trading. But what that measure does not tell us is how a share can have a high P-E and still be an attractive buy. That's where PEG is of help.

PEG is the ratio of a company's P-E to its earnings growth rate. A company with a high P-E can be an attractive buy if its growth rate is also higher than that of a comparable company with a lower P-E and slower growth

The lower the PEG, the better the share price. A PEG ratio below 1 means that the share is attractively priced and a PEG above 1 means indicates that it's expensive. Let's have the final word from Peter Lynch, as quoted in one up on Wall Street. "The P-E ratio of any company that is fairly priced will equal its growth rate. In general, a P-E ratio that is half the growth rate is very positive. A P-E ratio that is twice the growth rate is generally very negative."

While weighing whether a stock is attractively priced or not, one could do with an idea of how the share will be valued in a year or so. So a PEG based on expected earnings growth is qualitatively better than one based on current earnings.

Earnings estimate can be had from reputed research firms or can be taken as the average at which earnings have grown in the last 3-5 years. Stock Analysts often provide growth projections. But you will realize that reliable projections are not that easily available. That's one of the reasons why different people perceive the same share differently.

If good estimate are not available, a PEG based on the current P-E is the next best thing. You don't have to calculate the P-E; all financial newspapers carry it.

A comparison of only the P-Es would ignore the rate of growth in earnings. After all, the company with a higher growth rate would recover your investments faster. This is where PEG comes in.

Based on next year growth rates, the valuation gap between the banks would reduce if they stay at the price indicate in the table. But the aim is also to project what the future price could be, instead of assuming one.

PEG sets the pitch for rational economic evaluation - something that may not always be reflected in market sentiments. But one should heed a dictum of investor extraordinaire Warren Buffet's mentor, Ben Graham: "The stock market is a voting machine in the long term."

One caveat: PEG analysis by itself is not comprehensive enough, as it does not consider factors like management skills and overall asset quality. As ever, one is advised to supplement technical analysis with qualitative ones.