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Valuation: P/E And PEG Ratios

September 19, 2005

This is the first in a series of articles looking at how to value shares.

A few words of warning to begin with though. Valuing shares, or indeed any other asset, is not a precise science. It’s more of an art. There are no definitive answers to whether a share is cheap, expensive or about right. Most people use a number of valuation measures in order to get a feel for whether a share offers good value or not. It’s also important to be consistent about how you use valuation measures. For some methods, there are a number of different ways you calculate the answer. So, if you want to compare valuations at different times or for different companies, you have to make sure you’re comparing apples with apples and use the same method each time.

To start with, we’re going to look at the most popular valuation ratio — the P/E.

The P/E ratio

P/E stands price to earnings. You may have seen a comment like Dodgy.com trades at a forward P/E of 10, making it look fully valued, or Techtastic has a trailing P/E of 30, which makes it look cheap in comparison with other companies in the sector. But why is Dodgy.com considered fully valued and Techtastic thought to be cheap? And what is the difference between a forward and a trailing P/E?

The P/E is calculated as the company’s share price divided by its earnings per share (EPS). It can also be calculated as the company’s market value divided by its net profit (after tax but before dividends).

EPS is calculated as net profit (again, after tax but before dividends) divided by the number of shares the company has.

Let’s take an example, which should make this a little clearer. EPIC is a relatively new company but it is already profitable. Last year it made the conveniently round number of 1m in profit after tax. Even more conveniently it has 10m shares in issue on the stock market. So its EPS can be calculated as:

1m/10m = 0.10 or 10p

EPIC’s current share price is 300p, so the P/E is:

300p/10p = 30

This is a trailing or historical P/E because it is calculated on past profits. One way of looking at it is that a P/E of 30 implies that, at the current level of profits, it will take 30 years for you to get your money back. Yikes!

You can also calculate P/Es based on earnings estimates for the current year. The stock market is forward looking so many people prefer to use forecast (or prospective) P/Es rather than historical ones. So if EPIC was predicted to make 1.5m in profits next year that would make its forward EPS 15p and its forward P/E 20.

However, while historical numbers cannot change, brokers’ profit forecasts often do over the course of a year as the company releases new information on how it is trading. For this reason many people use these two P/E measures in conjunction to get a more complete picture.

But do these figures mean EPIC is incredibly cheap, wildly overvalued or somewhere inbetween? Many people often make a snap judgment about a company’s valuation based on its P/E. Usually they compare a company’s P/E with the overall market or with others in its industry.

Although this can be a useful starting point unfortunately you need to look a little deeper. That’s because the year you’re looking at in order to calculate the P/E may not be a good indicator of what level of profits will be generated in the future. In our example, perhaps the 1m in profit was mostly due to a one-off contract that won’t be repeated. Or perhaps it was just the initial stage of a large deal expected to generate much higher profits for many years to come. If you’re comparing a company’s P/E against the market or its industry then you also need to consider how much their earnings will grow over the coming years.

The point is that an investor needs a lot more information than the P/E number alone to attempt to put a value onto the company. That is because the P/E ratio, like many valuation measures, is a one-dimensional number. In order to get a more complete picture of whether a company is cheap or expensive you need to look at several valuation measures in conjunction.

The PEG ratio

The PEG ratio is cousin of the P/E ratio. It is calculated as the forecast P/E divided by the company’s EPS growth rate. Using the example of EPIC above, its forward P/E is 20 and its EPS growth rate is 50% (as its EPS was 10p last year and it is predicted to be 15p next year). This gives it a PEG of 0.4 (20/50).

Traditionally, a PEG below 1 is usually considered cheap while a PEG above 1 is expensive. However, as with all valuation measures, a pinch of salt is required. It is very hard to predict growth rates more than a couple of years ahead. If you only use a growth rate calculated over one or two years this may not be indicative of the long term trend. You may catch a period when the company’s profits are growing more quickly than usual or merely pausing for breath. If you merely look for shares with low PEGs, there is a danger you will tend to catch fad shares that grow quickly over a short period of time before fizzling out.

The PEG was a popular tool during the late 1990s when the relatively calm economic conditions meant that growth rates tended to be more predictable. Jim Slater, author of the Zulu Principle. was foremost in promoting its use. However, it is much less common to see it used these days, as it the ratio did not work well in recent years when companies were struggling. This is one of the main weaknesses of the PEG, it tends to break down at the extremes of low or very high growth. However, it can still be a useful tool for giving you an initial indication of whether a share requires further investigation.