Why you should PEG your P/E?

Before you read further, let me give you an insight from my family. There are people who “know” (like my father) – and they are mostly proved wrong. Then they are people who “know not” (like my mother) – and she is mostly lucky. And then there are people who “think they know” (like me) – and they mostly make an ass of themselves.

All of us know what PE means. Its the amount of dollars investors are ready to pay for each dollar of earning. For most of us it’s really simple. Low PE for a company that we know has prospects, makes it a good buy and vice-versa. To judge what’s low, we compare it to PE of the industry or to companies in the same business. Bada-bing Bada-boom .. done. And then we see these.

Symbol P/E
GOOG 94.55
MSFT 23.65
INFY 79.37
CTSH 54.03

Huh? I like Google, Larry Page is God etc. but I am no Moses. I am not confident that the Red Sea is going to part for me. Google doing 4 times (23.65 * 4 = 94.6) better than Microsoft sounds audacious. And lets not even talk about these third world companies trading at a P/E 2 to 3 times of Microsoft. What gives? Aha, but I am forgetting what I preached before i.e. stick to what you know. I am not utilizing my knowledge of the software industry. These might be in the same business as far as my mother is concerned. But, I a software engineer/ programmer/ hacker/ developer (excuse the bit of an identity crisis here) [1] should know better.

Infosys and Cognizant are software services providers, while Microsoft is in the business of developing operating systems and Google is all things internet. Maybe this is an apples to oranges comparison. We are still stuck though. Infosys and Cognizant are very similar. Microsoft and Google, though still different are rapidly approaching each other [2]. So if we were to stick with P/E’s buying MSFT is no brainer. Why aren’t the investors being rational? Why are they flocking to all these other companies? You might say “Investors – rational is an oxymoron and it’s called market sentiment you idiot.”

Maybe so, but lets give it one more shot. How about growth potential? Let’s look at the PEG Ratio which is (P/E ratio) / Annual EPS Growth Rate (It’s in %). You look at PEG the same way look at P/E the lower the PEG the better value for money. Actully PEG is not scientific its just a rule of thumb. The popular interpretation being, if its 1 the stock is fairly priced, less than 1 its cheap, and more than 1 its expensive.

Symbol P/E Annual EPS Growth Rate PEG
GOOG 94.55 100 (estimate) 0.95
MSFT 23.65 5.75 4.11
INFY 79.37 45.33 1.75
CTSH 54.03 48.79 1.27

The EPS Growth rate are over a 5yr period, values taken from TD Waterhouse. I pulled Google’s growth rate out of thin air (the basis being 633% growth in the last quarter) since it does not have a 5yr history.

Now that gives an entirely different picture. Doesn’t it? It makes MSFT look freaking expensive and Google damn cheap. Didn’t somebody say you can prove anything with statistics. Healthy circumspection aside, I do think that CTSH and INFY are good buys. They have shown very high growth rates for about 5yrs and even if they slow down I don’t expect them to slow down by a lot. I would keep away from Google. It may have grown by 633% last quarter, but the party is not going to last for long.

What about our rule of thumb? PEG’s for all of these are still above or close to 1. Let’s flip the argument and assume a PEG of 1 for each of these i.e. we assume all of these are fairly priced. That implies the market is expecting 95% growth from GOOG, 24% growth from MSFT, 80% growth from INFY and 49% growth from CTSH. Which of these expectations are more likely to come true? Look at the growth rate in the past 5 yrs, your gut feeling about the prospects of these companies and you will know what to do. Sell all your stocks and buy CD’s (i.e. if you are rational).

Lastly, what about fluctuations in dollar values. Yes, these can definitely have an impact on valuations of foreign companies like INFY and CTSH. But, its slightly more complicated. A stronger dollar normally cuts into returns from foreign companies [3]. In this case though – these companies (INFY and CTSH) get most of their revenues in dollars – a stronger dollar is going to boost their bottom line thus have a positive effect.

Footnotes

[1] My friends employed in large public companies can’t help pitying me. I went from a “Core Programmer” at Elixar to a “Computer Programmer” at nsoftware. And yes the job title definitely reflects my skills and job duties – I was programming the “CORE” at Elixar and I am programming the “COMPUTER” at nsoftware. Scared – you should be. I will say this much for the MBA’s in the software industry, they might suck at everything IT, but they sure can come up with sexy job titles – Systems Analyst, Solutions Architect ….

[2] Don’t forget the tirade from Steve Balmer about Google, the fight over an executive switching sides, MSN Live, the rumour about Google providing Office online etc. etc.

[3] Thanks to Eric for pointing out a significant factor involved in investing in foreign markets.

About amit

I was born in Kanpur, India in 1977. I did my schooling partly in Kanpur, Surat and Udaipur. I spent most of my schooling years in Udaipur in a boarding school. This was the most enjoyable period of my life predominantly because I made a lot of friends and played a lot of football (my first love). My school years brought in a sinking realization that I was good in academics, average in football [even after my most sincere efforts :( ] and to put it euphemistically ‘artistically challenged’. Hence cool careers in photography, sports, art & design or music were all beyond me.

I took up what I could do best, and enrolled for engineering at Nagpur University. College brought its own pleasures, I had my share of beers, bunked classes, read the ‘Bhagvad Gita’, learned yoga and picked up love for traveling. After graduating I was one of the lucky few to get a great job at Infosys Technologies. The best thing I got from my first job – my Yamaha Rx 135. There were not many weekends when I did not explore places in and around Bangalore on it.

In two years though my desire to pursue further studies caught up with me and I enrolled for a M.S in Computer Networking at North Carolina State University. Here I picked up basketball, love for stand up comedy, liking for the ‘other football’ and offcourse a little bit of computer networking. I graduated in Dec 2002 and am currently working for /n Software.

I am slowly evolving into a die hard Linux and Open Source enthusiast, trying to pick up skydiving, biking, running and photography. Some might call that progress. :)

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2 Responses to Why you should PEG your P/E?

  1. Vimal says:

    Nice article..I frankly don’t know about all these statistics, but i guess one needs to look deeper about differences in service-oriented & technology-oriented companies. More in this case, because INFY/ CTSH relies on these big tech-oriented companies and there is a good amount of coupling between them. Most of the contracts that INFY/CTSH gets is very heavily dependent on growth of companies such as Google/Microsoft/Cisco, depending on how much service they provide to them. Recognizing that, its common sense that if thier clients do well, they are gonna going to do well. So essentially it boils down to the fact that how much i am gonna (trust) invest in these bigger companies, which will eventually drive the revenues of these service-oriented companies. So if i am gonna put my money on INFY, at a deeper level, i am banking on some other companies health, who are giving their business to INFY.

    Also, the health of serv-orien companies cannot be determined alone by their financial state. You never know what next big contract they are going to get, which will boost up thier revenues. For ex. Wipro just bagged $300 M contract from GE. Even though INFY figures might be better than WIT, the deal is totally independent of that. Its like a volatile variable in C, if i put my programming knowledge to use :) – Another example, CSCO is gonna invest $1.5 B dollars in next few years in India. CSCO has vendor contracts with HCL, Wipro, INFY, and some other vendors. You will be surprised to hear that even though HCL name figures behind INFY/Wipro, HCL is one of the first vendors of Cisco, and probably the biggest bagger of their contracts.

    Keep your articles coming :) –

  2. Aditi says:

    U nerd!

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