How to choose undervalued stocks

Markets have been on a roll following the rush of liquidity, making it difficult to find value in stocks. The PEG ratio can come in handy here.

Why PEG is important?

While most investors rely on the price-to-earnings (PE) ratio to assess whether a particular stock is cheap or expensive, the conclusion can be highly subjective. To reach a better conclusion, the PE multiple is often viewed in contrast to the industry multiple or against the stock‘s historical valuations.

The PEG ratio is a variant that helps identify the true value of a stock, based on its earnings growth potential. The ratio is derived by dividing the stock’s PE by its annual earnings growth rate. While the PE already factors in the earnings, PEG takes into account the growth rate as well, making it a more favoured metric.

A PEG ratio of 1 signifies the stock is trading at its fair value and a ratio of less than (or greater than) 1 implies it is undervalued (or overvalued) relative to earnings growth potential.

The criteria

Using the Capitaline database, we shortlisted companies that have a PEG ratio of less than 1.

We used the compounded average earnings (EPS) growth rate (CAGR) of stocks over FY17 to FY20, to arrive at the PEG ratio at a first level. The forward earnings growth estimates can be a good sign of growth potential, assuming stocks return to normalcy in FY22. Hence, PEG based on FY22 consensus earnings estimates has also been considered at the next level, for the stocks that showed a PEG of less than 1 on the first criteria.

The PE multiple used is based on trailing twelve month earnings.

We only filtered out companies with consistent profit growth in all of the last three years. We have also eliminated entities that suffered losses in any of the last four years while calculating EPS CAGR from FY17 to FY20.

Besides, we considered only Nifty 100 companies (excluding BFSI) as a starting point to ensure adequate visibility and market interest.

While looking at PEG alone may not be the right way to zero in on your investment choice, this screener can sure be a starting point to undertake further research into the businesses we have highlighted below.

Who made the cut

GAIL (India) witnessed 11.8 per cent CAGR growth in earnings over FY17-20. The stock is currently trading at 7.5 times its trailing twelve-month earnings. The gas distributor, with a PEG ratio of 0.63 based on last three years’ earnings growth, made the cut. In the first half of FY21, its gas transmission and petrochem businesses saw improvements in margins but losses in the gas trading segment offset the overall increase in operating profit.

The sustained increase in LNG spot prices in Asia in the recent months, could help fillip the company’s trading gains in future. Another gas distributor also trades at a PEG of less than 1— Petronet LNG.

The company’s earnings have been growing at 17 per cent CAGR over FY17-20. After a drop in volumes in the first half of FY21, Petronet is already eyeing a ramp-up in volumes from strong utilisation in its Kochi utility (following the completion of Kochi Mangalore Pipeline). That apart a sustained price rise in LNG spot prices may further spur its earnings growth.

Infrastructure giant Larsen and Toubro (L&T) too made the cut. For an earnings growth of 17.02 per cent (CAGR) over FY17-20, L&T currently has a PEG of 0.8 based on FY17-20 earnings and 0.37 times based on FY22 earnings. In the first half of FY21, while the company saw slower execution due to manpower shortages, supply chain disruption and halt in operations, the coming quarters seem promising. While project execution would be back on track, with the economy gradually shifting to normalcy, the company has been bagging several large and significant orders in FY21.

A few names that came up in our earlier screeners also have a PEG of less than 1, when we expanded the scope beyond Nifty 100. If you do further research on Sonata Software (PEG of 0.8), Caplin Point Laboratories (0.5) based on our earlier screeners on return on equity, give them brownie points for their current PEG as well.