RIGHT Stocks @ RIGHT Price

Take guru Peter Lynch's investment mantra to heart -- one must first find the companies whose long-term prospects look good and have good management quality and then check whether their share price is under-valued using the PEG ratio.
PE ratio, that is the Price/Earnings ratio is a common valuation number used by investors in stocks. The PE number gives an idea as to whether the stock is under-valued or over-valued.
It is defined as: PE ratio = market price of the share / earnings per share.
However, the problem with PE ratio is that it is a meaningless number, by itself. Is PE of five good or bad? Or should it be 10? Or possibly say 25? Mathematically speaking, the lower a PE stock appears, it's considered better than a higher PE stock. But is it really so?
Why do we buy a stock? We buy it so that when its price goes up, we can sell it and make profit. But why should the price of the share go up? Again simple, the price would go up if the company makes higher profits i.e. higher earnings per share (There are, of course, many other reasons for share prices to go up, but from the fundamental perspective, the price of a share is ultimately a reflection of it's profits).
In other words, it is the growth in the earnings, which gets reflected in the share price. And since we are buying a share in anticipation that its price will go up in future, we must look at the expected growth rate of its earnings, especially over the next two-three years.
Comparing the two i.e. the PE ratio and the EPS growth of a company gives a more meaningful picture. PEG ratio or the Price Earning Growth Ratio is defined as: PEG ratio = PE ratio / EPS growth rate
PEG ratio=1 This means that the share price is fully reflecting the company's future growth potential i.e. the share at today's prices is fairly valued.
PEG ratio>1 This indicates that the share price is higher than the expected growth in the company's profits i.e. the share is possibly over-valued.
PEG ratio<1 This indicates that the share price is lower than the expected growth in the company's profits i.e. the share is possibly under-valued.
Therefore, the PEG ratio tells us something more about the future potential of the company. It tells us whether the high PE is a superficial number or is supported by future growth prospects.
Let us look at an example to get a better perspective. We have an information technology company whose PE ratio is 30 and expected EPS growth rate of 40 per cent. And then, we have a banking stock, with PE ratio of 12 and EPS growth rate of 8 per cent.
On the face of it, if we only look at the PE ratio, the banking stock looks cheaper and attractive. But what about the PEG ratio? Let's do the simple math:
IT company PEG = 30/40 = 0.75
Bank PEG = 16/8 = 1.50
Going by the definition of PEG ratio, we find that the IT company's share is undervalued considering its future growth prospects. And so its share price is likely to appreciate more than the bank stock.
However, as usual, there is a word of caution. Like any other financial number, the PEG ratio is not a law, but a very useful indicator of a whether a share price is under or over-valued. It cannot be looked at in isolation. One must:
Look at other numbers such as
P/B value, operating margins, return on equity etc.
Compare it with the peer group
Consider other non-financial factors too, such as brand value, management quality, barriers to entry etc.
This is so because we are only estimating the EPS growth. If our expectations of growth do not materialise, the share prices can fall. Or sometimes the market gives more value to things like brands.
This is so because, even if the growth rate does not justify a high price, the brand value acts as protection. Say there is a fall in the demand, then it is likely that large reputed companies will be less affected, than relatively unknown companies. There is a sort of stability of returns expected.
Therefore, to get the best out of this PEG Ratio, it may be prudent to follow investment guru Peter Lynch's advice - first, find the companies whose long term prospects look good and have good management quality and then check whether their share price is under-valued using the PEG Ratio.
sanjay.matai@moneycontrol.com

Get RICH mantras

Achieving health, wealth and happiness :

1. Start out with a clear idea of what you want, the clearer the idea the better your chances of achievement. Write it down clearly in a positive way and in the present tense. For example, if you want a car, clearly spell out what kind of car, what colour, what d�cor, and so on.
Let us say a Honda City in blue colour with beige faux leather interiors. Write down: 'I have a blue Honda City with beige faux leather interiors. It has a stereo system of the best quality from xyz, a television monitor, a DVD player, etc'

2. Picture yourself achieving your goal. If you are thinking of the car, picture yourself driving this car. See it in your driveway or parking lot. Give the picture a lot of colour and atmosphere such as smell (those who know will tell you that new cars smell different. For me it is an intoxicating smell), sound, etc. The better your visualisation, the faster you will get there.

3. Convince yourself of the definiteness of achieving your goal however absurd it appears initially. Dream big and see it as absolutely real. Conviction carries the day. Belief is all.

4. To assist you in your visualisation, prepare a scrapbook or a sheet of card paper and stick pictures of all the things you want in life. Only do not put people in it. For instance, you want a good partner, visualise your getting a good partner, the kind of person, his or her qualities and so on. Do not expect Marilyn Monroe to drop into your life, she is long since gone! If you are lucky and you desire it, someone who looks like her just might. . . so all the best!

5. Last of all there are two very important principles:
Be grateful for what you have and are getting everyday. Enjoy the sunrise and the sunset, the smell of flowers, the internet or whatever else you have, and say a silent thanks to all those who made this possible.