Decades of research and analysis by analysts has given us many valuation tools which can be used to value a company. Ratios such as P/E Ratio, Price to Book Value, Price to cash flow, EV/EBITDA and many others claim to provide you a quick relative valuation of the price you are paying against the earnings or asset of the company.

Out of all the valuation ratios, the one that has gained much popularity compared to any other is the P/E ratio.

P/E ratio stand for Price to earnings ratio. It is a quick way of comparing the price an investor is paying against the earnings per Share (EPS) of the business. The formula of P/E ratio is as follows:

P/E Ratio= Price/EPS(Earning Per Share)

The reason why P/E ratio is so popular is because it helps you clearly understand what you are paying against the earning of the business. If a company is has a high P/E ratio, it means you are paying a high price against the earnings of the business.

Despite its popularity, there are some serious flaws P/E ratio has that an investor must be aware of.

Although P/E ratio allows you to compare price of the company against earnings, what it does not account for is the future growth potential of the company.

So, if a company is trading at a low P/E, it may look like an attractive investment, but if the business of the company is not growing, it does not make a good investment compared to a company that is trading at higher P/E but has good growth in the business.

Because of this drawback of P/E Ratio, PEG ratio was developed by Mario Farina in 1969 in his book, A Beginner’s Guide To Successful Investing In The Stock Market.

Also Read: 5 Financial Ratios you should use to be a smart investor

PEG Ratio or Price to Earnings Growth ratio goes a step further in valuing the business. What differentiates PEG Ratio from PE Ratio is that PEG ratio also accounts for the growth potential of the company instead of valuing based on its current earnings.

PEG Ratio is calculated by dividing Price to Earnings Ratio with company’s estimated growth rate. For example if a company is trading at a P/E of 30 and its estimated growth rate is 25%, so the PEG ratio will be calculated as follows:

PEG Ratio= P/E Ratio/Growth

30/25=1.2

If a company has PEG ratio of less than 1, it means that the current value of the company is less than estimated future growth, and thus, company is assumed to be undervalued. If the PEG ratio of a company is equal to or more than 1, then it is assumed to be fairly valued and overvalued respectively.  

But how can P/E Ratio sometimes be misleading and how does PEG ratio give you the right picture? Let us understand with a real life example:

For this example we will compare two auto manufacturing companies, Tata Motors, and Maruti Suzuki.

The screenshot below is taken from Screener.in, and as you can see, Tata motors is Trading at a P/E of 11.64, while Maruti Suzuki is trading at a P/E of 34.81.

Looking at the P/E ratios, it is obvious that Tata motors is much cheaper than Maruti Suzuki.

But if you look at the growth of both the companies, you will find a completely different picture.

Assuming both the companies will keep growing the way they are, the PEG ratio of Maruti Suzuki is around 1.1 (P/E Ratio/Growth=34.81/31.56=1.1) while in case of Tata Motors, the PEG is -0.8( 11.64/-14=-0.8).

Clearly, despite low P/E valuation, Tata motors is not a good investment as it is facing decline in its profits. On the other hand, Comparatively, Maruti Suzuki is attractive as its trading at a PEG of 1.1, which means stock despite being slightly overvalued is growing.

As you can conclude from the example above, P/E ratio, despite its popularity, is not a great way to value a business and thus must be used cautiously. The PEG ratio on the other hand is relatively better measure of company’s value as it accounts for the expected future growth. So next time, before you pick a stock based purely on the P/E rato, just pause for a moment and check its PEG to understand the complete picture.

Also Read: Valuation Ratios: What are they hiding from you?