Should you value a stock using P/E to growth ratio?

Finding value in the stock market can be challenging, especially at a time when the Philippine Stock Exchange Index is trading at historical highs.

The easiest way to tell if a stock is expensive or cheap is to compare its price-to-earnings (P/E) ratio with the market average. If the P/E ratio of a stock is higher than the overall P/E of the market, the stock is deemed relatively overpriced and if the P/E is lower than the average, the stock may be undervalued.

But market wisdom tells us that stocks that grow faster than the market deserve to trade at a higher P/E ratio. The market will always pay a premium for stocks that have high potential for increased earnings.

In order to make the comparison easier by incorporating earnings growth outlook into the equation, there is one metric that has been prominently used in recent years. It is called the P/E to growth ratio, or simply PEG ratio.

According to this indicator, a stock is considered fairly valued if its P/E ratio is equal to its growth rate, which yields a PEG ratio of 1.0. If a stock has a PEG ratio of less than 1.0, meaning the P/E of the stock is less than its growth rate, the stock is deemed undervalued, while if the PEG ratio is greater than 1.0, the stock is thought to be expensive.

Let’s apply this tool in comparing two stocks that belong to the same sector, Ayala Land Inc. (ALI) and Alliance Global Inc. (AGI).

At first glance, ALI’s P/E ratio at 20.9x will look more expensive than AGI’s P/E ratio at 11.7x, but if you consider ALI’s growth of 15.5 percent according to market consensus as compared to AGI’s expected growth of 5.9 percent, ALI emerges as relatively cheaper with lower PEG ratio of 1.35x as against AGI’s PEG ratio of 2.0x.

While the PEG ratio may seem to be a useful tool in identifying relatively undervalued stocks particularly in a bull market where P/E ratios tend to be inflated, there are fundamental limitations to this concept that lessen its reliability.

For example, Meralco, a mature stock that pays regular dividends, currently trades at P/E ratio of 20x but has expected earnings growth rate of only 6 percent. Does this mean the stock is overpriced at PEG ratio of 3.3x? Does the stock deserve to trade at 6x P/E considering its historical dividend yield of about 5 percent?

What about if the stock has negative growth rate? PLDT currently trades at 21x P/E based on market consensus, but its expected growth rate is a negative 5.7 percent, yielding negative PEG ratio of 3.7x. Should the stock trade at the lowest single digit P/E ratio even though it has positive earnings?

The median PEG ratio of the stock market as represented by PSE index stocks is about 1.88x with median growth rate of 10 percent. If the PEG ratio argument were to be followed, the market at current P/E of 18x should already be deemed overvalued though it is still comparatively lower by historical reference.

While PEG ratios are supposed to improve the use of P/E ratios by adjusting it with future growth, it fails to make any adjustments for risks as potential source of differences in valuation. What are the risks that the company may not achieve its earnings growth for the next five years?

PEG ratios ignore the fact that the intrinsic value of a stock is determined by growth and risks. The value of a stock may be increased with higher growth but not without higher risks, which account for differences in fundamentals.

Despite increasing popularity of PEG ratio as a valuation tool, this ratio is only useful as a quick and dirty way of determining potential mispricing in stocks for further research but it should not be used more than a rule of thumb in determining basis for value investing.