In a market hurt by external shocks, value investing is fast gaining popularity. The success of value investors like Warren Buffett further underscores this. Buffett and his business partner, Charlie Munger managed to register 20% compound annual growth in the market value of Berkshire Hathaway from 1965 through 2020 compared with 10.2% rise of the S&P 500 during the same period.
However, while searching for a suitable investment option, value investors with varied risk appetite are unlikely to consider price/earnings to growth (PEG) ratio among a number of other popular metrics like price/earnings (P/E), price/sales (P/S) or price/book value (P/B).
This is because they often find this ratio complicated, considering the limitations in calculating the future earnings growth potential of a stock. Yardsticks, such as dividend yield, P/E or P/B, are most commonly used to single out stocks trading at a discount.
However, these ratios, while not taking into account the future growth potential of a stock, might end up convincing us to invest in stocks that are at a discount just because of their poor show. This might often lead to “value traps” — a situation when these value picks start to underperform over the long run as the temporary problems, which once pulled down the share price, turn out to be persistent.
In such a case, even if you buy a stock at less than its fair value, you might still end up paying more. And here comes the importance of this not-so-popular but crucial value investing metric, the PEG ratio.
The PEG ratio is defined as: (Price/ Earnings)/Earnings Growth Rate
A low PEG ratio is always better for value investors.
While P/E alone fails to identify a true value stock, PEG helps find the intrinsic value of a stock.
There are some drawbacks to using the PEG ratio though. It doesn’t consider the very common situation of changing growth rates, such as the forecast of the first three years at a very high growth rate, followed by a sustainable but lower growth rate over the long term.
Hence, PEG-based investing can turn out to be even more rewarding if some other relevant parameters are also taken into consideration.
Here are some of the screening criteria for a winning strategy:
PEG Ratio less than X Industry Median P/E Ratio (using F1) less than X Industry Median (for more accurate valuation purpose) Zacks Rank of 1 (Strong Buy) or 2 (Buy) (Whether good market conditions or bad, stocks with a Zacks Rank #1 or 2 have a proven history of success.) Market Capitalization greater than $1 Billion (This helps us to focus on companies that 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 5% (Upward estimate revisions add to the optimism, suggesting further bullishness.) Value Score of less than or equal to B: Our research shows that stocks with a Style Score of A or B when combined with a Zacks Rank #1, 2 or 3 (Hold) offer the best upside potential.
Here are seven out of the 50 stocks that qualified the screening:
Stellantis N.V. ( STLA Quick Quote STLA - Free Report) : This is one of the world's leading automakers and a mobility providers, guided by a clear vision to offer freedom of movement with distinctive, affordable and reliable mobility solutions. Stellantis has a long-term historical growth rate of 20.7%. The stock currently carries a Zacks Rank of 1 and has a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here . SnapOn Incorporated ( SNA Quick Quote SNA - Free Report) is a global provider of professional tools, equipment, and related solutions for technicians, vehicle service centers, original equipment manufacturers and other industrial users. Products include a broad range of professional hand and power tools; vehicle diagnostics and service equipment; business management systems; and other tool and equipment solutions. The company currently holds a Zacks Rank #2 and has a Value Score of B. It also has an impressive five-year expected growth rate of 9.5%. LG Display Co., Ltd. ( LPL Quick Quote LPL - Free Report) is the world's leading innovator of display technologies, including thin-film transistor liquid crystal and OLED displays. The company manufactures display panels in a broad range of sizes and specifications primarily for use in TVs, notebook computers, desktop monitors, and various other applications, including tablets and mobile devices. Apart from a discounted PEG and P/E, the stock currently sports a Zacks Rank #1 and has a Value Score of A. PetroChina Co. Ltd. : This is the largest integrated oil company in China. It operates in four segments: Exploration & Production, Natural Gas & Pipelines, Refining & Chemicals, and Marketing. It has an impressive long-term historical growth rate of 46.3%. The stock currently has a Value Score of A and carries a Zacks Rank of 1. Sanmina Corporation ( SANM Quick Quote SANM - Free Report) : This is a leading integrated manufacturing solutions provider serving the fastest growing segments of the global Electronics Manufacturing Services (EMS) market. The company currently holds a Zacks Rank #2 and has a Value Score of A. It also has an impressive five-year expected growth rate of 12%. ArcBest Corporation ( ARCB Quick Quote ARCB - Free Report) : This company is a leading logistics company with creative problem solvers who deliver innovative solutions for its customers' supply chain needs. Apart from a discounted PEG and P/E, the stock currently sports a Zacks Rank #1 and has a Value Score of B. It also has an impressive five-year expected growth rate of 15.3%. ON Semiconductor Corporation ( ON Quick Quote ON - Free Report) : This is an OEM of a broad range of discrete and embedded semiconductor components. The company currently holds a Zacks Rank #2 and has a Value Score of B. It also has an impressive five-year expected growth rate of 45.3%.
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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: https://www.zacks.com/performance.
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