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Second Pillar of Investing - Avoid investing in overvalued companies - The Power of PEG: A More Comprehensive Valuation Metric Than PE Ratio
I have written a series of posts on Fragility Analysis. You can find the posts here Fragility Analysis | Budget Tiger (budgetiger.in)
By eliminating fragility in our investments, we can avoid steep drawdowns upon an adverse news/event. While analysing a company from a fragility perspective, we need to look at three important pillars.
Pillar 1 : Avoid investing in fragile companies. We can measure the fragility of a company through financial statement analysis.
Pillar 2: Avoid investing in overvalued companies as overvaluation makes our investment fragile
Pillar 3: Avoid investing in companies whose Management has fragile mindset
Each of the three pillars are important. In this post, I would like to explain more on Pillar 2 i.e. Avoid investing in overvalued companies.
The most commonly used valuation metrics are the Price to Earnings (PE) ratio and the Price to Earnings Growth (PEG) ratio. However, while the PE ratio has been a popular go-to for investors for years, the PEG ratio offers a more nuanced, holistic perspective.
The Limitations of the PE Ratio
The PE ratio, which is calculated by dividing a company's market price per share by its earnings per share (EPS), is a simplistic measure of a company's value. It essentially tells us how much investors are willing to pay for each Rupee of earnings generated by the company. However, the PE ratio has a significant drawback: it doesn't account for the company's growth prospects.
In other words, the PE ratio can mislead investors into overvaluing stagnant companies with high earnings or undervaluing high-growth companies with currently low earnings. For example, a company growing at 30% y-o-y and trading at a PE of 20 is undervalued as compared to a company growing at 10% y-o-y and trading at a PE of 10.
This leads us to the concept of the PEG ratio.
The PEG ratio, on the other hand, takes the PE ratio and adjusts it for the company's earnings growth rate. It's computed by dividing the PE ratio by the earnings growth rate.
By incorporating growth into the equation, the PEG ratio provides a more balanced view of a company's valuation, offering insight into whether its stock is overpriced or underpriced given its earnings growth trajectory. Essentially, it allows investors to compare the relative trade-offs between the price of a stock, the earnings generated per share, and the company's growth.
Understanding Earnings Growth Rate in PEG Ratio
Earnings growth rate is a crucial component of the PEG ratio, providing the denominator that adjusts the PE ratio to account for the company's growth prospects. This rate can be determined based on past performance, future projections, or a combination of both.
When using historical earnings growth rate, we can look at the past 5 or 10 years. This approach provides insight into the company's demonstrated ability to grow its earnings over time. So we can arrive at PEG by dividing PE with past 5 years earnings growth or dividing PE by past 10 years earnings growth.
However, it's worth noting that past performance is not always indicative of future results. For example, earnings of most companies were impacted during COVID-19 years i.e. FY2021 and FY2022. Arriving at historical growth rate based on FY2022 with earlier years is not a right indication. Economic conditions, industry trends, and company-specific factors can all impact a company's future earnings growth, making the past growth rate only as a guidance factor.
On the other hand, using projected earnings growth for the next 5 or 10 years offers a forward-looking perspective. However, they also introduce an element of uncertainty, as they rely on assumptions about future conditions.
Ultimately, the choice of earnings growth rate period (past vs. future, 5 years vs. 10 years) depends on our risk tolerance, and belief in the company's prospects. Some investors may prefer to use a blend of historical and projected growth rates to balance the stability of past performance with the potential of future growth.
Why a PEG of 1 or Below is Considered Favorable
In terms of interpretation, a PEG ratio of 1 suggests that the company is fairly valued given its growth rate. A PEG ratio below 1 typically indicates that the stock may be undervalued – that is, investors may be underestimating the company's ability to grow its earnings in the future. This could potentially lead to higher than 15% Compound Annual Growth Rate (CAGR), making these companies attractive for investment.
The Unsustainability of High Growth
While a low PEG ratio may signal an undervalued high-growth company, it's crucial to understand that high growth rates are often not sustainable over extended periods.
For example a company with PEG of 1 and PE ratio of 300 implies the company is required to grow its earnings at 300%!!! y–o-y for the stock to justify appreciation of just 15% CAGR.
Companies, especially those in their growth phase, may experience extraordinary growth rates. However, as they mature, their growth rates typically taper off, settling closer to the average growth rate of the economy. Furthermore, market saturation, increased competition, regulatory hurdles, and other factors can also slow down a company's growth over time.
So it is very very difficult to sustain hyper growth rates.
Wipro Limited was trading at PE of ~500 in Feb 2000. However, it took 15 years to again reach the same price in March 2015. Whether the company did not grow during this period? No, actually profits grew from Rs 112 Crs in FY1999 to Rs 7991 Crs in FY2014 at a scorching pace of 33% CAGR during this period. Still investors who invested at PE of 500 did not earn any return for 15 years. Because to even justify a return of 15% for the investor at PE 500, a company is required to grow its earnings at 500% per year i.e. the company is required to multiply its profits by 6 times every year!! Which is next to impossible just like light escaping a black hole due to its gravity.
In conclusion, while both PE and PEG ratios have their place in valuation analysis, the PEG ratio's incorporation of growth offers a more comprehensive view of a company's value. However, investors should be mindful of the fact that high growth rates are often not sustainable over the long run. Therefore, as with all investment decisions, it's essential to combine these.
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