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PE Ratio of India: Is it Sustainable or Risky?

2 Mins 14 Aug 2024 0 COMMENT

India is considered a high-valuation country, yet it is also one of the fastest-growing economies. Are these factors aligned? Let’s explore this in a brief video.

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PEG Ratio - Favourite Stock Picking ratio of Peter Lynch

Ace American investor Peter Lynch Managed the Magellan fund from 1977 to 1990 and consistently delivered 2x of S&P 500 index returns. To be precise, Peter Lynch generated 29.2% annual returns. Further, in 1989, he wrote the best-selling book "One Up on Wall Street," which we would also recommend for you all to read.

In this book, he has shared how his favourite metric for stock analysis is none other than PEG ratio i.e. price earnings to growth ratio. Thus, in today’s article we will discuss the importance of PEG ratio and why it is so important.

Before we understand what PEG ratio is, let us first discuss two investment approaches i.e. value investing & growth investing.

Let's begin with value investing. In this approach, investors look for stocks that are trading at a price lower than their intrinsic value. To do so, some important metrics are used, such as the price-to-earnings (P/E) ratio. Let's understand how the P/E ratio is calculated.

The P/E ratio is nothing but the company's share price divided by its earnings per share. Instead of using the price of a single share or earnings per share, you can also divide the company's market cap by its overall net profit and get the same result. In short, the P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. A high P/E ratio could mean that a stock's price is high relative to its earnings and possibly overvalued. Conversely, a low P/E ratio might indicate that the current stock price is low relative to earnings.

Let's take an example:

Let us look at Company A. It has a market cap of 1000 crores and net profit of 100 crores. So it P/E ratio will be 1000 divided by 100, which is 10. Generally, low P/E ratio is considered favourable for investment. Value investors tend to search for and prefer to invest in undervalued stocks. This is due to the fact that undervalued stocks typically have good fundamentals and enjoy a higher chance of share price appreciation in the future. In growth investing, investors favour fast-growing companies even if they look expensive on a valuation basis. Let's consider Company B. Like Company A, it also has a profit of rupees 100 crores, but there's one twist: 5 years ago, the profit of Company A was rupees 100 crores, but at the same time, the profit of company B was 40 crores rupees, which has now grown to be around 100 crores. Chances are the company B has a higher valuation, even if we assume it has a market cap of rupees 2500 crores or a P/E ratio of 25. Investors may prefer Company B because of its fast-growing profits.

So now, if you are getting one signal from the value investing approach and another signal from the growth investing approach, what should you do? There is a ratio through which one can adjust the company's value for its growth rate and get a better picture than looking at value or growth alone. This is the PEG ratio.

Now let us understand the same with the help of an example: As we saw earlier, the P/E ratio of company A was 10 and its historical profit growth is 5%. Also, in the past 5 years, its profit only grew from rupees 80 crores to rupees 100 crores. In applying the PEG ratio, we will divide its P/E ratio by its growth rate, meaning, 10 divided by 5, and the answer is 2. Whereas, when we consider company B, its P/E ratio is 25 but it growth rate is around 25%. Now, when we apply the PEG ratio to company B it comes to 1. In simpler terms, the PEG ratio tells you how the company's valuation looks like after you adjust it for growth rate. The lower the PEG ratio, the better it is. After all, Company A looks attractive on a standalone P/E ratio basis of only 10, but it is also growing at only five percent, whereas Company B demands earnings multiple of 25, but it is also growing at 25 percent.

Remember, top investors such as Warren Buffett don't blindly chase companies only if they look cheap on a valuation basis. In fact, they prefer to buy strong or fast-growing companies, even if it means you don't get a bargain deal. As Buffett says, "It is better to buy a wonderful company at a fair price rather than a fair company at a wonderful price."
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5 Guidelines for Beginner IPO Investors

Know the intention of the company behind raising the funds. Before investing understand how the company plans to use the funds. If the intention is only to repay debts, the IPO may not be an attractive investment. However, if the company plans to invest the fund in both repaying the debt and expanding the business, it might be something you would want to consider. For this you should read the prospectus of the company.

Do not fall for big names, instead understand the business of the company well. It is a good practice to do a SWOT analysis to study the continued opportunity of the company in the market in the future. If the business is unclear or if the study fails to show you the company’s growing capacity to capture market share in the future, you might want to stay away.

Check important financials and ratios of the issuer company. Before investing, you should study the year-on-year financials of the company. Other than their revenue, you should also read the financial reports of financial aspects such as Net Worth, Profit After Tax, Total Assets, and Borrowing. The financial report will also provide you with an idea of ​​the important ratio such as PE ratio, RONW, ROC, ROE, and Debt to Equity ratio.

The performance of the IPO and the market trend are closely linked. The market trend lies on several major factors and its performance may affect the IPO. However, these factors only follow the movement of the stock market, they don't lead it. Last but not the least, do your own research and do not follow any one blindly, not even your guru while investing in the market.

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