When analysts can’t stop extolling about the effectiveness of the most common and uncomplicated valuation metric – the price-to-earnings ratio, one could find another metric, the price-to-earnings-growth ratio (PEG), which is more effective in identifying value stocks. PEG, as its definition goes, uses three parameters – Price, Earnings and Earnings Growth Rate – and hence is a bit complicated to calculate.
However, difficulty does not always mean you should avoid it. In fact, at this stage of global uncertainty, market volatility has reached a peak over the past one year. As a result, all the basic and simplest tools that were earlier sufficient to find safe and sound stocks have been called into question.
Whateverthe market conditions, price-to-earnings ratio can’t single handedly predict winning stocks. We definitely need other yardsticks to assess the intrinsic value or fair value of a particular stock. PEG is in fact one of the most important ratios to judge the fair value of a stock.
The PEG ratio is defined as: (Price/ Earnings)/ Earnings Growth Rate
A lower PEG ratio is always better for value investors.
Why PEG over P/E?
For value investors, considering PEG over price-to-earnings or P/E can be more rewarding as it helps in finding cheap stocks with future growth potential.
Let us crunch some numbers.
A company with a P/E ratio of 35 and a growth rate of 20% would have a PEG ratio of 1.75 (35 / 20 = 1.75) while a company with a P/E ratio of 40 and a growth rate of 50% would have a PEG ratio of 0.80 (40 / 50= 0.80).
If we only consider the P/E ratio, the first company with a lower P/E will obviously be in a better position (discounted state). But if we add the growth rate to justify the P/E, the scenario gets reversed.
However, PEG cannot perform magic alone; we need other relevant parameters to create a successful investment strategy. Let’s fine-tune the screening criteria to arrive at a winning combination.
Screening Criteria:
PEG Ratio less than X Industry Median
P/E Ratio (F1) less than X Industry Median
Zacks Rank #1 (Strong Buy) or #2 (Buy): Whether good market conditions or bad, stocks with a Zacks Rank #1 (Strong Buy) or #2 (Buy) have a proven history of success
Market Capitalization greater than $1 billion: This ensures that the companies have strong liquidity)
Average 20 Day Volume greater than 50,000: A substantial trading volume ensures that the stock is easily tradable.
Percentage Change F1 Earnings Estimate Revisions (4 Weeks) greater than 10%: Upward estimate revisions add to the optimism, leading to stocks price appreciation.
Here are five of the 11 stocks that qualified the screening:
Yamana Gold, Inc. (AUY)
Newell Brands Inc. (NWL)
Newmont Mining Corporation (NEM)
ACCO Brands Corporation (ACCO)
USG Corporation (USG)
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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Disclosure: Performance information for Zacks’ portfolios and strategies are available at: http://www.zacks.com/performance.
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