The PEG Ratio

Construction Obstruction

The PEG Ratio

Caterpillar and Cummins

Since moving to Florida 20 years ago, I’ve seen many changes. That’s a long span of time, so change is expected. Florida’s population has grown 45% during the past 20 years while the total U.S. population has grown 24%. Some states, including Nevada, Arizona, Utah, Idaho, Colorado and Georgia, grew at faster rates, whereas West Virginia, Rhode Island, North Dakota, Michigan, Ohio and Pennsylvania barely grew at all during the past 20 years.

It’s nice to live in a rapidly growing area. There are lots of new things to explore such as a new aquarium, a new Salvador Dali Museum, a new Legoland and expansions at Disney World, Busch Gardens and lots more. Why mention Legoland? Legos are all the rage for youngsters, and my grandson can’t wait to see the giant Lego figures that are bigger than his own Lego creations. Legoland opens in the fall, so he’ll have to wait a bit.

As with other burgeoning areas in the United States, Florida has not been able to build infrastructure fast enough to meet expanded demands for utilities, highways, bridges, etc., even though the roads around here undergo never-ending expansion and upgrades.

Access to our community is via U.S. Highway 19, which runs north and south along much of the western side of Florida. The highway has been overcrowded and dangerous for many years, but several projects have eliminated some traffic lights and travel lanes have been added. The latest construction project involves elevating the highway to eliminate three more traffic lights.

The new construction will improve our traffic flow and hopefully make it safer for us, but the inconvenient access to our community is getting nerve-racking and time consuming. And the project won’t be completed until September 2015. Ugh!

I have noticed that much of the machinery used in our road construction project comes from the same company. One can’t miss the letters CAT boldly displayed on the sides of bulldozers, front end loaders, backhoes and the like. Caterpillar has been the clear leader in construction machinery for decades in this country and is firmly entrenched in many other countries as well. Before I give you my thoughts on Caterpillar, a quick review of fundamental stock analysis might be helpful.

Fundamental analysis is any method used to evaluate a company, and by extension, its stock. Fundamental analysis includes just about all types of analysis except chart reading.

I found out long ago that reading a stock chart does not suit my scientific approach to investing. As I’ve mentioned a time or three, I need numbers, formulas and tangible results.

For the past 25 years, I’ve been using a system designed to find undervalued growth stocks. The system uses the PEG ratio and works remarkably well.

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 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 dividend growth. Quality companies are seldom extreme bargains, but high-quality companies will likely produce dividend income and price appreciation.

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 called the S&P Quality Ranking.

Companies with A+, A, and A- S&P Rankings are 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 six years, I’ve recommended companies with low PEG ratios every six months in my newsletter, the Cabot Benjamin Graham Value Letter. My recommendations have increased 51% compared to an advance of 11% for the Standard & Poor’s 500 Index during the same six-year period. High-quality stocks with low PEG ratios have consistently outperformed the stock market indices in both advancing and declining markets. Investing in growth stocks at bargain prices makes sense in any stock market environment.

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Two good examples of high-quality companies with low PEG ratios are Caterpillar (CAT) and Cummins (CMI). These companies have PEG ratios of less than 1.00, which meets my objective.

My calculation of CAT’s PEG ratio of 0.83 is based upon the current stock price of 111.18, my forward 12-month earnings per share estimate of 7.25, and my estimated five-year earnings per share growth rate of 18.5%. Standard & Poor’s Quality Ranking for CAT is A+, which indicates the company has produced very steady earnings and dividend performance during the past five to 10 years.

My calculation of CMI’s PEG ratio of 0.84 is based upon the current stock price of 106.55, my forward 12-month earnings per share estimate of 7.70, and my estimated five-year earnings per share growth rate of 16.5%. Standard & Poor’s Quality Ranking for CMI is B+, although I expect Standard & Poor’s to boost CMI’s Ranking to A- based on the company’s strong balance sheet and steady earnings and dividend performance during the past 10 years.

Caterpillar (CAT), founded in 1925, is the world’s largest manufacturer of earth-moving equipment. In addition, the company makes diesel and natural gas engines, industrial gas turbines and diesel-electric locomotives. Caterpillar equipment is used in mining, logging and farming, and in the construction, petroleum and transportation industries.

On July 8, 2011, Caterpillar completed the purchase of Bucyrus International for $8.8 billion. Bucyrus makes monstrous trucks, excavators, shovels, drills and underground mining equipment used in the mining of coal, iron ore, copper and gold. Bucyrus generates 30% of its sales in North America and 70% from other parts of the world. Sales in 2010 totaled $3.7 billion compared to $42.6 billion for Caterpillar.

Financial results for the second quarter could be muted, as a result of parts shortages stemming from the disaster in Japan. However, during the remainder of 2011 and well beyond, demand for Caterpillar and Bucyrus equipment will be especially strong as a result of the need to replace aging construction and mining equipment.

The necessity for additional equipment to rebuild not only the devastated areas of Japan, but also extensive areas of the U.S. affected by recent tornadoes and floods will increase, too. In addition, roads, highways and bridges in the U.S. and other developed countries are in dire need of refurbishing and improvement, and the rapid development of infrastructure in emerging countries such as Brazil, China and India provides a bright outlook for Caterpillar for an extended period of time. I believe Caterpillar offers excellent short-term and long-term appreciation potential with minimal risk.

Sales will likely increase 13% and earnings per share 18% during the next 12 months led by the recent acquisition of Bucyrus. The dividend was recently increased for the 18th straight year and now provides a 1.7% yield. At 15.1 times my 12-month forward EPS estimate, Caterpillar is undervalued.

Cummins (CMI) designs, manufactures, distributes and services engines of all types, plus electrical power generation systems. The engine division (49% of sales in 2010) manufactures and markets a broad range of diesel and natural gas-powered engines under the Cummins brand name for heavy- and medium-duty trucks, buses and recreational vehicles. Founded in 1919, the company has long-standing relationships with many truck makers, including Chrysler, Daimler, Volvo, PACCAR, Navistar, Komatsu, Ford and Volkswagen.

While sales in the U.S. have been weak, Cummins has taken advantage of strong demand abroad, especially in China, India and Brazil. Sales increased 66%, 31% and 39% respectively during the first quarter in those countries. Foreign sales account for 61% of total sales with more sales to China than any other country outside the U.S.

Demand for CMI’s heavy truck engines in the U.S. is expected to rebound significantly during the next two years. Stricter emission standards around the world will increase demand for the company’s clean-running engines, fuel systems and exhaust components.

Sales and earnings per share will likely increase 15% during the next 12 months, boosted by CMI’s strong position in emerging markets. The dividend was recently increased and now provides a 1.5% yield. At 13.8 times our 12-month forward EPS estimate, Cummins is undervalued.

Until next time—be kind and friendly to everyone you meet.

Sincerely,

J. Royden Ward
Editor of Cabot Benjamin Graham Value Letter

Editor’s Note: You can read more about PEG Ratio analysis and get continuing coverage of Caterpillar and Cummins in the Cabot Benjamin Graham Value Letter. There you’ll not only find buy and sell advice for Caterpillar and Cummins, you’ll get 20 other excellent value stock recommendations from J. Royden Ward each and every month. Roy applies the strategy of the father of value investing, Benjamin Graham, to find the market’s best undervalued stocks. And he will tell you exactly when to sell, too. Roy’s recent sell recommendations netted his investors gains of 62%, 39%, 36% and 32% in just six months using the PEG ratio system. Remarkable! Don’t miss out on his next recommendations … click here now to get started today!

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