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Here's how to put the ratio to work. Say Infosys is trading at a forward P/E of 35 times earnings. After making the comparison and discovering that rivals Satyam and Patni Computers are both trading at multiples around 20, one might begin to think Infosys looks awfully expensive.
But then you look at earnings growth. First, we see that Infosys earnings are expected to grow at 40% annually over the next three to five years, while analysts are predicting Satyam will grow at 15% and Patni Computers at 20%. That would give Infosys a PEG of 0.88, while Satyam weighs in at 1.33 and Patni computers at 1. Looked at in that light, Infosys doesn't seem so pricey after all.

Generally, we use a forward P/E in the PEG ratio, but a low PEG using a trailing P/E is even more convincing. Anything below 1 is of interest, although there really are no rules of thumb. Like the P/E, different industries regularly trade at different PEGs. It's also true that the PEG works less well for large-cap companies that by nature grow at a slower rate despite strong prospects. As always, the key is to compare a company to its peers.

The PEG ratio's weakness is that it relies heavily on earnings estimates. In 1998, for instance, some companies in the oil-services sector routinely had projected earnings growth rates in the 35% range. But by the end of the year, the crash in oil prices had them swimming in losses. Had one been impressed by their bargain-basement PEG ratios, one has lost a lot of money.

These risks aside, however, the PEG ratio is another useful tool for an investor to have besides P/E ratio, like the instruments lined up as the surgeon prepares to operate.

Concluded.

* Contributed by: -
Varun Dawar,
PGDBM, Batch 2004-06,
Institute of Management Technology (IMT), Ghaziabad.