The PEG Ratio

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 value investing. As I’ve mentioned a time or three, I need numbers, formulas and tangible results.

For the past 29 years, I’ve been using a system designed to find undervalued growth stocks. The system uses the PEG ratio and works remarkably well.

Twenty-nine 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.

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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 Investor. 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.

Timothy Lutts

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