The PEG Ratio Strategy

This week, I’m going to focus on a profitable strategy that uses the PEG Ratio for determining a company’s under or overvaluation.

The PEG Ratio goes beyond the P/E to find value stocks regardless of their growth rate.

The PEG ratio is simply the P/E divided by the Growth Rate. Many believe this ratio tells a more complete story than just the P/E. A PEG ratio of 1 or less is considered good (par or undervalued) while greater than 1 is thought to be poor (overvalued). Less than 0.5 is generally thought to be excellent.

A company with a P/E of 25 and a Growth Rate of 20 would have a PEG Ratio of 1.5 (25 / 20 = 1.25).

While a company with a P/E of 40 and a Growth Rate of 50 would have a PEG Ratio of 0.8.

Traditionally, investors would look at the stock with the lower P/E and deem it a bargain (undervalued). But looking at it closer, you can see it doesn't have the growth rate to justify its P/E.

The stock with the P/E of 40 though, is actually the better bargain since its PEG Ratio is lower (0.8) implying it’s undervalued with more potential value. (Undervalued in relation to its projected growth rate.)

In other words, the lower the PEG, the better the value, because the investor would be paying less for each unit of earnings growth.

So for this week’s screen, I’m using the PEG Ratio and only three other filters to find winning stocks. The parameters are:

Zacks Rank Average Broker Rating PEG Ratio And all of these stocks have to be trading >= $5.

The results:

I ran a series of tests, using a four week rebalancing period over the last 3+ yr. time span.

The results showed that over the last 3+ years (1/5/01 thru 6/11/04), the annualized yearly gross return is 63% with a win ratio (winning periods) of 78%. (Its gross return since inception is a remarkable 389.6%. This compares with the S&P 500, which comes in at -9.2% during the same period.)

Specifically, in 2001, the PEG strategy showed a 48.5% return. In 2002, a 46.2% return. And in 2003, a whopping 114% return.

Year-to-Date it’s up over 5% and currently has 28 stocks qualifying this winning strategy.

Here’s three stocks from that list.

ACE - Analyst Report ACE Limited
RS - Snapshot Report Reliance Steel & Aluminum Co.
TNP - Snapshot Report Tsakos Energy Navigation

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