There has been a ton of bullishness about the Price/Earnings-to-Growth (PEG) ratio being a great indicator to buy stocks. Motilal Oswal’s wealth creation studies did a great job explaining that buying stocks below a PEG of 1 and especially 0.5 lead to good wealth generation.
Hence it has become a habit for investors to compute PEG to compare the valuations of two companies.
For example, let’s say the P/E (Price-to-Earnings) of ABC Ltd is 30 and its growing Earnings Per Share (EPS) by 25% and the P/E of XYZ Ltd is 20 and is growing its EPS by 10%. On the face of it, company XYZ looks cheap but adjusting for growth, i.e., the P/E ratio divided by growth PEG is 1.2 for ABC and 2 for XYZ, which means A is cheaper relative to B.
Contrary to what people believe, the PEG ratio of two businesses are comparable if they are from the same business segment, same industry and comparable capital structure (D/E), but in the real sense, the PEG of two business are comparable if the following is comparable: Length of sustainable growth, predictability of growth, return on equity above discount rate, Competitive advantage (for how long can ROE be maintained above discount rate) and quality of earnings irrespective of what business segment and industry they belong to.
Let’s take a look at Divi’s Laboratories vs Alembic Pharma. Suppose we are standing at the beginning of FY 2017, and these are the numbers from the past few years:
So, Alembic Pharma grew at a much higher rate than Divi’s Laboratories and still was available at a much lower PEG ratio than Divi’s Laboratories making a compelling undervaluation case for Alembic. Can you guess the returns of Alembic Pharma and Divis from FY 2017- FY 2022?
Alembic Pharma has broadly remained at the same level with an all-time high of ~1100, whereas DIVI’s has become a 3.5 bagger from April 2016 with an all-time high of 5300.
On the valuation and historical growth front, it seemed that Alembic Pharma by far would outperform Divi’s Laboratories, but the real scenarios turned out completely inverse. (PS: the main reason is Alembic’s growth/margins are not linear as there are one-time gains/losses due to stiff industry competitiveness at the generic level. Whereas Divi’s growth & margin profile is more linear giving market confidence about future growth. However, this is not a comment on the quality of businesses; we are trying to explain how the market reacts in terms of valuations)
This is the point we wanted to highlight, blind comparison of any valuation ratio, even if it’s a sophisticated one like PEG, does not make sense. There are fundamental drivers of every valuation ratio. In an article shortly, we will also teach you how to calculate a company’s intrinsic PEG ratio, i.e., the PEG ratio a company should deserve depending on its fundamentals.