The dependency of EPS, P/E, PEG with Expected Rate of Return: A

Study on Indian Manufacturing Company

Janga Sainath Reddy
Sabyasachi Basu
Introduction
The earnings & earnings to growth model and its use to determine the expected return on equity
capital is being implied by current prices and forecasts of future payoffs is comparable in certain
respects to internal rate of return (IRR) calculated from market prices of a bond and the coupon
payments.
P/E ratio is simply the market price of a share divided by Earnings per Share pf that particular
share, is a popular mean of combining prices & forecasts of earnings implicitly for comparing
expected rates of return
On the other hand, PEG ratio is the ratio of P/E and % growth in eps, proponents of which take in
account the differences in short-run earnings growth. However, some research paper doesnt
agree to the same.
But taking in account several other factor & refining the PEG ratio maybe helpful in determining
the effects of various factor on the cost of equity as well as the effect of capitalized earnings on
the Price of the share.
The model is based on Ohlson & Juettner-Nauroths (1995) and Peter D. Eastons research work.
A few modifications are made in forecasting the next periods earnings and in case of abnormal
growth.
Ohlson has pointed out that a possible limitation of these studies is many of them rely on
CleanSurplus assumption in the forecast of the future book values and this assumption rarely
holds practical matter. The residual income valuation model is also becoming of wide application
on Wall Street.
The model talks about if the next periods accounting earnings is equal to economic profits, then
the earnings are sufficient for valuation and expected rate of return is equal to inverse of the price
to expected earnings.
We have taken up 15 companies listed under NSE, India and 10 years of their data, to test our
hypothesis, starting from 2002-2011; giving us an opportunity to justify our approach in the
following years.
The paper follows the following process. (1) Development of a model to determine the
relationship between prices, forecasts of earnings and forecasts of earnings growth. (2)
Structuring the PEG ratio. (3) Dependency of P/E ratio on Capitalized earnings. (4) Valuation of
a company through valuation of Equity. (5) Condition of Economic Profit equals to Abnormal
Earnings

Model of PEG ratio

The Price/Earnings to Growth (PEG) is a stock's price-to-earnings ratio divided by the growth
rate of its earnings for a specified time period. Price/Earnings to Growth (PEG) is a stock's pricetoearnings ratio divided by the growth rate of its earnings for a specified time period. The pricetoearnings ratio (P/E) is a fairly simple tool for assessing company value. The P/E ratio is
popular and easy to calculate. But it has big shortcomings that investors need to consider when
using it to assess stock values. This comparison of the PE ratio and the earnings growth rate as a
basis for stock recommendations is captured in the PEG ratio.

Previous Studies
Despite its increasing popularity as a valuation tool, the academic literature on the PEG ratio is
scarce. The pioneering study seems to be by Peters (1991), who focused on the compounding
power of PEG-sorted portfolios. He found that between January 1982 and June 1989, $1 invested
in the lowest-PEG portfolio, rebalanced quarterly, would have turned into $15.36, whereas $1
invested in the highest-PEG portfolio, also rebalanced quarterly, would have turned into just
$1.38. (In the same period, $1 invested in the S&P500 turned into $3.56.)
More recently, Sun (2001) found that PEG ratios and stock returns were negatively related \
during the period July 1983-June 2000, though the significance of the relationship largely stems
from the first half of the sample. He also finds a hump-shaped relationship between PEG-sorted
portfolios and returns, with low-PEG portfolios and high-PEG portfolios earning lower returns
than mediumPEG portfolios.
These results are not very supportive of the PEG as a valuation tool and cast doubt on a low-PEG
value strategy.
Easton (2002), in contrast, reports more optimistic results. He proposes a method to
simultaneously estimate expected returns and earnings growth (thus refining PEG-based
rankings), and finds that expected return estimates based on the PEG are highly correlated with
those based on the refined methodology. He concludes from these results that PEG ratios are a
reasonable first-order approximation to a ranking on expected returns.

Data and Methodology

Two of the main fundamental factors that may explain differences between the P/Es of
comparable companies (or, more generally, between a companys P/E and its appropriate
benchmark) are growth and risk. This can be easily seen from the following expression:

P0 =
Where,

(1)

P0 = current, at t=0, price per share

P1 = expected, at t=1, price per share dps1
= expected dividend per share, at t = 1 r =
expected rate of return & r>0
The central valuation role of forecasts of next periods accounting earnings is examined by
adding (and subtracting) capitalized expected accounting earnings, eps1/r to equation (1) and
focusing on the term that remains when capitalized accounting earnings is separately identified.
Adding and subtracting capitalized accounting earnings yields:

P0 =

-[ -

] _________(2)

If expected accounting earnings eps1 is equal to economic earnings (which may be defined as
rP0), the term in square brackets must be equal to zero in other words, next periods expected
earnings are sufficient for valuation. However, if eps1 does not equal economic earnings,
valuation based on accounting earnings requires forecasts beyond the next period.
The role of forecasts of accounting earnings two periods ahead may be seen by rewriting
equation (2):

P1 =

[ -

] ________(3)

Putting (2) in (1)

P0 =

+
(

+
(

_____(4)
(

Where,
ae1 = eps2 +r*dps1 (1+r)*eps1
(5)
This abnormal earnings reflects the effects of generally accepted accounting practices that lead to
a divergence of accounting earnings from economic earnings. To see this note that if eps 1 and
eps2 were equal to economic earnings ae 1 would be zero and the ratio of expected earnings-toprice would be equal to the expected rate of return.
The valuation role of expected accounting earnings beyond the two-year forecast horizon may be
seen by recursively substituting for P2, P3, P4, etc., in (4) & (5) to yield:

P0 =

(6)
(

Where,
aet = epst+1 + r*dpst + (1+r)*epst
Hence, by considering a perpetual rate of change of abnormal earning,

P0 =

(8)
(

At ae = 0,

r2 r*

At, dps = 0,

r=
P =
If, g = g = g3 = . = g

P
dps = b * eps ;where, b = payout ratio
Assumptions,

(7)

=0

1. g1 < g2 < g3 2. g1 > g2 > g3 3. g1 = g2 = g3 4.

g1 = g2 = g3 = gn =0
P
At, g = 0,

P0 =
=>

Valuation of a company,

Next, we introduce our general model for a firms market value of equity (a.k.a. market cap).
This model allows for growth in earnings and introduces the concept of normal versus
abnormal earnings. The market value of a firms equity at time t (P) is:

P = BV0 +
(

When,
Abnormal Earning = Economic Profit
If eps1 and eps2 are equal to economic earnings, the expected rate of return is equal to the ratio of
forecasted earnings-to-current price. If eps1 and/or eps2 are not equal to economic earnings, ae1
will be non-zero and ae captures the future change in abnormal accounting earnings to adjust
for this difference between accounting and economic earnings.

Pt = NIt In order to get maximum Pt;

Must be minimum.

Hypothesis
H0: Growth in EPS reflects to expected Rate of Return of a Company
H1: Growth in EPS doesnt reflects to expected Rate of Return of a Company

Research Design
The EPS, Share Price of 15 different companies listed on NSE are taken as research data.
Table1: EPS Growth and Cost of Equity
Company

Growth EPS

Average(r)

Hindalco
Nalco
Hindustan Motors Ltd
Maruti Suzuki India Ltd
ABC Bearings Ltd
NRB Bearings Ltd
SKF India Ltd
Timken India Ltd
ACC Ltd
Birla Corporation Ltd
UltraTech Cement Ltd
India Cements Ltd
Madras Cements Ltd
Gammon India Ltd
Hindustan Construction Company Ltd

0.134564916
0.112586699
0.116392893
0.422840729
0.225270093
0.127187869
0.338166297
0.055476462
0.478893534
1.010931868
0.327987861
0.248285039
0.259541641
0.220778143
0.058427682

0.155698158
0.203925055
0.256234244
0.139249937
0.409633364
0.193776586
0.161712438
0.119055724
0.155653519
0.256373807
0.174731423
0.354324878
0.187924484
0.167030028
0.261464189

SUMMAR
Y OUTPUT
Regression Statistics
Multiple R
R Square

0.0329399
0.001085037

Adjusted R -0.075754576
Square
Standard
0.248921116
Error
Observati
15
ons
ANOVA

df

SS

MS

Regressio
n
Residual

0.0008
75
0.0619
62

0.0141
21

Total

14

0.0008749
49
0.8055023
85
0.8063773
35
Standard
Error
0.1855718
78

t Stat

P-value

1.3748
59

0.1924
09

0.8168508
42

0.1188
31

0.9072
26

13

Coefficients
Intercept

0.255135234

Average(r)

0.09706719

Significan
ce F
0.907226

Lower
95%
-0.14577

Upper
95%
0.6560
39

-1.66763

1.8617
66

Table 2: Cost of Equity and PEG

Company
Hindalco
Nalco
Hindustan Motors Ltd
Maruti Suzuki India Ltd
ABC Bearings Ltd
NRB Bearings Ltd
SKF India Ltd
Timken India Ltd
ACC Ltd
Birla Corporation Ltd
UltraTech Cement Ltd
India Cements Ltd
Madras Cements Ltd
Gammon India Ltd
Hindustan Construction Company Ltd

SUMMARY OUTPUT
Regression Statistics
Multiple R 0.100078999

Average(r)
0.1556982
0.2039251
0.2562342
0.1392499
0.4096334
0.1937766
0.1617124
0.1190557
0.1556535
0.2563738
0.1747314
0.3543249
0.1879245
0.1670300
0.2614642

PEG
0.782596
1.378404
3.219784
0.294764
0.251387
1.05812
0.457024
3.321228
0.35321
0.095654
9.321168
1.429365
0.714606
1.135303
4.403563

Lower
95.0%
0.145
77
1.667
63

Upper
95.0%
0.6560
39
1.8617
66

R Square
Adjusted R
Square
Standard
Error
Observati
ons

0.010015806
-0.066136824
2.507479818
15

ANOVA
df

SS

MS

Regressio
n
Residual

0.8269
44
6.2874
55

0.1315
23

Total

14

0.826943
602
81.73691
551
82.56385
912
Standard
Error
1.869338
151

t Stat

P-value Lower
95%
0.2011 -1.5214
51

Upper
95%
6.5555
15

8.228458
209

0.3626
6

0.7226
86

14.792
36

13

Coefficients
Intercept

2.517055682

Average(r)

-2.984138441

1.3464
96

Significa
nce F
0.722686

-20.7606

Lower
95.0%
1.521
4
20.76
06

Upper
95.0%
6.5555
15
14.792
36

Conclusion
We described a model of earnings and earnings growth and we demonstrated how the model may
be used to obtain estimates of the cost of equity capital. We developed and demonstrated a
procedure for simultaneously estimating the implied market expectation of the rate of return and
the implied market expectation of the long-run change in abnormal growth in earnings for a
portfolio of stocks. Our finding is despite of having a high expected rate of return the companies
are not having high eps growth. Hence the Price of the company gets affected. Though in a few
companies the eps grew significantly resulting in overvaluation. The general downward bias in
the estimate of the expected rate of return based on the PEG ratio is shown to be higher for firms

with higher PE, higher PEG ratios, lower standard deviation of past returns, higher market
capitalization, and lower expected short-term earnings growth rates.

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