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What drives up a price of a share? Any investor worth his or her salt will quote ratios like EPS-earning per share, or the PE-the price earning ratio-and possibly they will be right. After all, earnings are the bottom line and how much profit a company earns, is what separates the winners from the losers. It all comes down to earnings. More than any other figure in a financial report, earnings -- and the prospect of higher earnings in the future -- determine whether investors will continue to bid up share prices. Earnings are the bottom line that show how much money a company can use to reinvest in business growth or to pay dividends to shareholders.

Earnings are usually summed up as earnings per share -- the company's net earnings divided by the number of common-stock shares outstanding. Earnings per share, or EPS, offers a handy way to compare past earnings to spot upward or downward trends. Some investors measure stocks almost entirely by how much profits grow from quarter to quarter and year to year. EPS, however, only gives a starting point to evaluate stocks. It does not take into account the stock's current price.

This is where the price-earnings ratio comes in. The price-earnings ratio, or P/E, is the price of a company's stock divided by its EPS. It is one of the most widely used tools in sizing up stocks. Simply put, it is how much investors are willing to pay for a rupee of the company's earnings. You may also hear it referred to as a "multiple." Theoretically when you calculate a P/E based on the past year's earnings, the P/E is called "trailing, or historical." When you're considering historical P/Es, a lower ratio is often more attractive because investors may be getting a bargain.

But things start to get a bit fuzzy when future projections come in to play, so here the market tries to determine the forward PE based on the future earnings projections. This is the "forward" P/E (also referred to as the "anticipated" P/E). Now mostly in real life scenario what we see quoted as the PE is a measure which is a mixture of both. The PE ratio has already incorporated into the price of the scrip any news –good or bad and projected earnings of the company for the coming year. This is exactly what the term "discounted the news and earnings" means.

But how does one evaluate a company's growth? One common method is to look at the price/earnings growth ratio. The price/earnings growth, or PEG, ratio is the P/E divided by the projected earnings growth rate. First, determine the projected growth rate using current EPS and next year's estimated EPS.

Company A: ( 5.00 - 2.50 ) / 2.50 = 1 = 100%

Company B: ( 1.25 - 1.00 ) / 1.00 = 0.25 = 25%

Company A's earnings are expected to grow 100% over the next year, while Company B's should grow 25%. Next, plug in the forward P/E, since the idea is to look at the company's future prospects. The PEG calculation would look like this:

A: 21 / 100 = 0.21

B: 28.8 / 25 = 1.152

Theoretically a PEG ratio of 1 is considered standard -- in other words, its growth rate is already incorporated into the price of its stock. Anything higher than 1 means that the stock is trading at a premium to its growth rate. A PEG ratio lower than 1 shows that a stock may be undervalued. Company A, with a PEG of 0.21, may look like a good buy, with good potential for growth. Company B's stock price has already been bid up to incorporate its potential growth over the next year. Also because of the PEG ratio, the scrip may undergo a rerating wherein the PE ratio improves and the resultant PEG ratio comes closer to 1.

Investors would do well to keep an eye out for unusually high P/Es. The higher the P/E, the greater investors' expectations. The greater the expectations, the faster the stock can plummet if those expectations aren't met. And something to keep in mind when using forward P/E and PEG ratios: These measures are dependent on analysts' projections, which can often be off the mark or flat out wrong. Don't rely solely on these numbers to pick a stock. Instead, use them as a piece of the puzzle of information necessary to determine if a company is worth your investing your money.

Aru Srivastava

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