How do market experts predict future index levels? It is done by estimating EPS (Earnings Per Share) of the index and then multiplying it with what they consider a logical multiple (P/E Ratio). In past 18 years, Sensex’s EPS has grown from Rs 81 to Rs 1270 (E) as show below –
As per analyst estimates, Sensex is expected to do an EPS of 1055 in FY2011 & 1270 in FY2012. This information should be taken with a pinch of salt as these are predictions. And predictions can be based on speculation. Capital Mind has an interesting post on senselessness of EPS projections.
A little calculation shows that in last 18 years, EPS has grown at 17.1%. Analysts predict that EPS for next 2 years is expected to grow at more than 20%. But considering present challenges of high inflation, high interest rates & global macro events, it seems to be a little too optimistic.
So how do we decide whether markets are fairly valuing future growth or not?
To answer this question, we use the PEG Ratio. It was popularized by Peter Lynch in his book One Up on Wall Street.
PEG Ratio is calculated as follows –
There is no hard and fast rule of which growth rate one should take. One can either take an estimate of future earnings growth or an average of the past earnings growth.
At present Sensex is trading at a multiple of 16.7 (Get latest P/E from here; For Nifty50, you can check this analysis too) and we take average EPS growth rate of 17.1% in our calculations. This gives us a PEG of 0.97 (=16.7/17.1).
So how do we interpret this number?
- Normally, a PEG of greater than 1 indicates an overvalued company, and less than 1 indicates an undervalued company. So a PEG of 0.97 indicates that at present, Sensex is fairly valued.
- Lower the PEG, the lesser one has to pay for each unit of future earnings growth. So, to put it simply, one should be interested in low PEG values.
- Consider a situation where you have a stock with low P/E. Is it that the market does not like the stock? Or is it that the market has overlooked a fundamentally strong stock of good value? To figure this out, we look at the PEG ratio. Now, if the PEG ratio is big, we know that this is probably because the “earnings growth” is low & this is kind of stock that the market thinks is of not much value. Now consider another situation where the PEG ratio is small. It may be because the projected earnings must be high. We know that this is a fundamentally strong stock that market has overlooked.
But PEG is not a fool proof way valuing future growth and there are a few issues –
- In strictest of sense, it is more of a rule of thumb rather than a formula. Reason being that the two sides of the formula have different units: you’re comparing a fraction with a percent.
- It works well with normal values of growth rates only. For certain values, the results can be absurd. For example, it implies that a company with zero growth should sell for a P/E of 0.
An interesting but technical take on PEG Ratios can be found here. Drawbacks of PEG ratio can be found here.
Important note: You must understand that the PEG ratio relies on the projected % earnings. These earnings are not always accurate and so the PEG ratio is not always accurate. Also, being just a ratio it should be looked in conjunction with other ratios and numbers.