The PEG Ratio
The Benjamin Graham Approach
Reinsurance Group of America
Today, I’m going to skip the small talk and jump right into my investing topic–fundamental stock analysis. Let’s start off with my definition as a value investor: Fundamental analysis is any method to evaluate the prospects of a company and/or its stock by analyzing the qualitative and quantitative factors of the company.
There are hundreds of ways to determine whether a stock is undervalued or not. Some methods always work well, while other methods work for only a short time. Some methods are complicated, but others are simple.
I have been using a couple of simple systems during the past 25 years that really work well. The first system is designed to find undervalued growth stocks, and the second system is designed to find bargain-priced value stocks. I call the first system the PEG (price/earnings to growth) ratio and the second the Benjamin Graham system.
Twenty-five years ago, Standard & Poor’s created the PEG ratio to measure the degree to which a growth stock is undervalued. I use the ratio to find high-quality growth stocks selling at reasonable prices. The PEG ratio is calculated by dividing the price to earnings (P/E) ratio by the earnings growth rate. The price used in the P/E ratio is the stock’s most recent closing price.
Earnings consist of estimated earnings per share (EPS) for the next 12 months. The growth rate (the “G” in the PEG ratio) is the estimated rate of EPS growth for the next five years. A PEG ratio of less than 1.00 indicates that a stock is undervalued. The lowest PEG ratios are best.
In addition to a low PEG ratio, I look for good quality companies with a history of steady earnings and dividends growth. Quality companies may not be extreme bargains, but high-quality companies will likely produce dividend income and price appreciation upon which you can rely.
There is a very simple measure to determine which companies are high-quality and have produced steady earnings and dividend performance during the past five to 10 years. Standard & Poor’s evaluates most stocks and assigns a ranking that they call the S&P Quality Ranking.
Companies with A+, A and A- S&P Rankings indicate high quality. I generally like to find companies with these rankings, although I will often include a company with a B+ ranking, if I believe the company has good prospects and a solid balance sheet with little debt.
During the past five years, I have recommended companies with low PEG ratios every six months in the Cabot Benjamin Graham Value Letter. My recommendations have increased 22% compared to a decline of 7% for the Standard & Poor’s 500 Index during the same period. High-quality stocks with low PEG ratios have consistently outperformed the stock market indexes in advancing and declining markets. Investing in growth stocks at bargain prices makes sense in any stock market environment.
A good example of a high-quality company with a low PEG ratio is Atlantic Tele-Network (ATNI). The company has a PEG ratio of 0.51, which is very low. My calculation of ATNI’s PEG ratio is based on the current stock price of 44.15, my 2010 earnings per share estimate of 5.00, and my estimated five-year earnings per share growth rate of 17.3%. Standard & Poor’s Quality Ranking for ATNI is A-, which indicates the company has produced steady earnings and dividend performance during the past five to 10 years.
Atlantic Tele-Network, based in Salem, Massachusetts, is a telecommunications company operating advanced wireless and landline networks and both terrestrial and submarine fiber optics in North America and the Caribbean. The company acquires small telecomm companies and builds additional infrastructure to serve rural communities.
Seven significant acquisitions during the past eight years allow ATNI to provide wireless, local telephone and data, Internet and long distance services in Guyana, Bermuda, the U.S. Virgin Islands, Turks & Caicos and rural areas of the U.S.
Atlantic Tele-Network is ready to complete what is by far its largest acquisition to date. The company will acquire 800,000 Alltel subscribers from Verizon Wireless for $200 million cash. Verizon was required to divest these subscribers to receive approval for the purchase of Alltel. The price being paid by ATNI is very reasonable.
Atlantic Tele-Network’s deal, scheduled to close in March 2010, will triple the company’s sales. The company earned $2.65 per share in 2009 and will likely earn $5.00 in 2010 and $6.25 in 2011. Sales were $246 million in 2009 and should increase to $565 million in 2010 and $700 million in 2011.
Atlantic Tele-Network has increased its dividend every year during the past 12 years. The latest increase brings the dividend yield up to 1.8%. At 8.8 times my 2010 EPS forecast and with a PEG ratio of 0.51, ATNI shares are a bargain.
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Benjamin Graham is known as the father of value investing. He influenced many modern investors, including Warren Buffett. Ben Graham wrote books, taught investment courses and created several methodologies to help investors evaluate stocks.
I have used one of Benjamin Graham’s methods for the past seven years in the Cabot Benjamin Graham Value Letter with great success. The method is based upon minimum price-to-earnings ratios, price-to-book value ratios and measures of quality. The full description of this analysis can be found in Benjamin Graham’s book, “The Intelligent Investor.”
Mr. Graham suggested that investors should buy stocks that fit all of the following criteria:
(1) The current price-to-earnings (P/E) ratio is 9.0 or less.
(2) The price-to-book value (P/BV) ratio is 1.20 or less.
(3) The long-term debt-to-current assets ratio is 1.10 or less.
(4) The current assets-to-current liabilities ratio is 1.50 or more.
(5) Earnings per share growth during the past five years is 1% or more.
(6) The company currently pays a dividend.
(7) The Standard & Poor’s Quality Rank is B+ or better.
The list of seven requirements is somewhat long, but several stock screening sites, as well as your favorite broker, can find stocks that meet most or all of them.
Using this analysis, my recommendations have soared 64% during the past 12 months through January 29, 2010 and have easily beaten the stock market indexes during the past seven years.
One of the stocks that currently stands out, because it easily fits all of the criteria, is Reinsurance Group of America (RGA).
RGA is a reinsurer and offers life, annuity, critical care and group reinsurance. The company guarantees insurance contracts for insurance and other financial companies. RGA sells its products in 26 countries around the world. The reinsurance industry has declined during the past several years because of the availability of competing reserve financing solutions including derivatives. I believe this downward trend has begun to reverse recently because of the turmoil in the financial markets and the problems with derivatives.
Reinsurance Group is in position to capitalize on the significant growth opportunities provided by the resurgence of the reinsurance industry in the U.S., as well as China and India. The company has over $2.2 trillion of life reinsurance in force backed by a strong balance sheet with conservative bond investments. Revenues increased 15% in the quarter ending 12/31/09, which was well above our estimate. Earnings per share were up 17%, which also exceeded our estimate. I believe the reversal has begun and that EPS growth of 14% is realistic in 2010.
RGA is the second largest provider of life reinsurance in the U.S. The company’s shares are undervalued at 8.1 times current EPS with a 1.0% dividend yield. RGA shares sell at 0.86 times current book value. The balance sheet is strong, and the Standard & Poor’s Quality Rank is A-. Reinsurance Group’s shares offer a solid investment choice for dividend income and stock price appreciation during the next two to three years.
J. Royden Ward
For Cabot Wealth Advisory
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