For sectors that have a long history, use of P/E ratios is less risky. However, for sectors that do not have much of a past, like software, the P/E ratio should be used with extreme caution.

Infosys, in February 2000, touched a peak of Rs 16,932. This would translate to a P/E multiple of 382x its FY00 earnings. Yet many investors bought the stock as if there was no tomorrow, only to repent later. In times of irrational exuberance, the P/E ratio can give a clue about the insanity in valuations. In this article we look at how the P/E ratio can help you avoid making such hazardous investment decisions.

Let us start with what is the P/E ratio. P/E ratio is calculated by dividing the market price of the stock by the EPS (earnings per share).

Earnings Per Share, EPS (Rs)= Profit After Tax ---------------- No of shares outstanding Price to earnings ratio, P/E (x)= Market Price --------------- Earnings Per Share (Rs)

The P/E ratio can be looked at as a price tag: that is, how many times the earnings ratio is the market willing to pay to be part of the company's fortunes. The reciprocal of the P/E ratio (dividing 1 by the P/E) would give the earnings yield on the stock.

For example if the P/E of a stock is 12, then reciprocal works out to 8.3 per cent yield. Another way of looking at the P/E ratio is that if the company's earnings did not grow at all in the future, it would take company P/E number of years to get back the money invested into the company. When Infosys was trading at a P/E multiple of 382 times, assuming no growth in earnings it would have taken 382 years for the company to earn the investment back for the investor. We are looking at some really long-term investors here.

And of course no one is willing to wait perpetually to get a return on his or her investments. Thus, the higher the P/E multiple investors are willing to pay, greater will be the hopes of getting the investment amount back in a shorter time horizon. Therefore, generally a high P/E would be based on expectations of higher growth in earnings.

More often than not, P/E ratio is used as relative valuation tool. Different companies from the same sector are compared on the basis of this ratio. Also, many times sector averages are used as a benchmark to compare valuations of different companies.

However, creating sector averages are prone to errors. We have an average P/E of 27x (for FY04) by taking six companies in a sample for the software sector. For example, if Hughes Software were to replace Wipro, the P/E could come down from 27x to 24x.

Company	Market Cap (Rs bn)*	PAT (Rs bn)	P/E (x)	Company	Market Cap (Rs bn)*	PAT (Rs bn)	P/E (x)
Wipro	341	10	33.0	Hughes	17	1	22.0
Infosys	347	12	27.9	Infosys	347	12	27.9
Satyam	97	6	17.5	Satyam	97	6	17.5
i-flex	40	2	22.2	i-flex	40	2	22.2
Geometric	3	0	11.8	Geometric	3	0	11.8
MphasiS	17	1	16.9	MphasiS	17	1	16.9
Sector	844	31	27.0		521	22	23.9

*All numbers for FY04.

However, the greater risk that is embedded in a relative valuation exercise that uses P/E multiple is that there is an intrinsic assumption that the markets are valuing the firms in question correctly. This is a very brave assumption to make. This might not be the case always.

While the investor has to take into account the fact that the markets do generally tend to be correct, the same markets do end up with average P/E ratios of 27x for a sector. Therefore, to get a bearing on realistic P/E ratios investors can use two methods and thus, cross check to find a rational price for the stock.

• First method is to calculate a P/E ratio for a stock and compare it with the P/E ratios the markets are using.
  

• Second method is to look at the PEG ratio. That looks at the P/E ratio in light of the future growth in earnings.
  

In the past we have seen that stock price is a function of the expected dividends in the future. Therefore, we have

D P0 = ---- r-g PO= stock price D= Dividend expected at the end of the year r= required rate of return g=perpetual growth rate expected

For calculation of rate of return please follow this link Expected rate of returns

Dividend can be also expressed as = EPS x Payout ratio Modifying we have PO = EPS0 x Payout ratio *(1+g) ----------------------------- (r-g) Where EPS0 is the current EPS for the company Therefore, P0 = Payout ratio*(1+g) ---- ----------------------- EPS0 (r-g) P0 = P/E ---- EPS0 Therefore, P/E = Payout ratio*(1+g) ------------------- (r-g)

HLL that has a pay out ratio of about 90 per cent, has seen earnings grow at a CAGR of 25 per cent between 1986 and 2004. Assuming a perpetual growth rate of 10 per cent for the company and a required rate of return of 14 per cent the P/E ratio works out to be 14x times. The stock is currently trading at a P/E multiple of about 17x. Obviously, the markets are factoring in a slightly higher growth rates.

Thus, based on the same assumptions for calculating the stock price, the P/E ratio can be estimated. However, the problem with this method is that retail investors need to make assumptions about the discount rate, payout ratio and perpetual growth rates.

Since these are not widely available it would be very difficult to approximate. And if any one was to make the effort, why not calculate the stock price? There is merit in the argument. We want to point out here that many times P/E ratio is used because there is a misconception that while using P/E ratios the need to make assumptions about the above mentioned variables are eliminated. However, one must appreciate that this is not a number pulled out of a hat, but the ratio is determined by the same assumptions that go into determining the stock price.

However for those who do not want to get involved in the complex process of valuing a stock the PEG ratio, is a tool that can help.

The PEG ratio is the ratio of the P/E ratio to future growth in earnings. This is based on the thumb rule that the P/E ratio should be equal to future earnings growth for the stock. Therefore, if the stock has a P/E ratio of 35, this should be supported by earnings growth of 35 per cent in the future.

It is preferable to use a CAGR for next two to three years. The future growth rates can be determined from company's earnings guidance or research reports on the companies that give projections about future earnings. Equitymaster's research reports give three-year forward projections for companies under our coverage.

Thus, this helps to justify whether the EPS has future growth potential to support the P/E. In that sense this becomes an indispensable tool for the investor.

PEG = P/E ratio (x) ----------------- Growth in earnings (%)

The number is calculated by dividing the P/E ratio by the expected growth in earnings. For example, Infosys has a P/E of 28x (based on FY04 earnings) and the CAGR growth in earnings is expected to be 22 per cent. Therefore, the company's PEG ratio will be 1.3 (28/22).

The use of the PEG ratio is however based on a thumb rule and is not a valid financial law. The two sides of the formula have different units: you're comparing a fraction with a percent, meaning that a factor of 100 has magically appeared on one side only.

Taking on from here investors should be very cautious about stocks that are trading at PEG ratio's of more than 0.8.

Company	*Current Market Price	EPS (FY07E, Rs)	P/E (x)	CAGR (FY02E-FY04E)	PEG
Infosys	5,235	337	15.5	21.9%	0.7
Wipro	1,447	77	18.9	19.9%	0.9
Satyam	310	31	10.0	20.4%	0.5

* As on 3rd June 2004 close

Wipro and Infosys look highly valued based on the PEG ratio. However, this ratio does not reflect the huge amount of cash these companies are carrying on their balance sheet. Infosys has around Rs 6,000 m ($ 125 m) balance sheet if its buys a business at a market cap to sales ratio of 1.5x spending Rs 3,000 m ($ 62.5 m), the company can add about 8 per cent to its topline.

The thumb rule that the P/E ratio should be equal to the future growth in earrings for a stock is actually based on the time value of money. The P/E ratio is an indication how much should investors pay for a company? A company that is growing twice as fast is worth twice as much.

But PEG is not suitable to value cyclical companies like semiconductors and chemical manufacturers, airlines, utilities, or financial companies like banks. It is also not useful in valuing large, well-established companies.

Also, a low PEG ratio might not mean necessarily mean that the company is undervalued. There a lot of certain facts about a company that the P/E ratio does not reflect like the amount of debt in the company.

There are two parts to selecting a company the first one is about finding out a viable business model and second part is about finding a correct price for the stock or put a correct value to the stock. In this article we have looked at trying to put a value to the stock but more the focus has been to a clue on how realistic valuations are. All these tools can only aid.

However, all these tools can also be used against you to justify things like the information technology revolution, which ultimately turned out to be an evolution. They are no substitute for rational thinking and patience.

For high growth stocks like Infosys a two-stage model has to be used. A growth rate and payout ratio is assumed for the super normal growth period. A lower growth rate and higher payout ratio is assumed for subsequent period of time.

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