The simplest method to decide on whether a stock is overvalued or discounted is to determine its price-to-earnings ratio (P/E) and compare it with the P/E of the market or peer group. If you find the stock’s P/E is higher than that of the market, you can conclude that it is an expensive bid and vice versa.
However, the problem arises when a stock apparently with an attractively lower P/E faces a dearth of catalysts to propel future growth. In such a case, if you buy the stock depending solely on its lower P/E, you might still end up paying more on the risk that the stock may falter soon. To avoid such value traps, Warren Buffett advises investors to focus on the earnings growth potential of a stock while judging the intrinsic value. And here lies the importance of a not-so-popular 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 to find the intrinsic value of a stock.
Unfortunately, this ratio is often neglected due to investors’ limitation to calculate the future earnings growth rate 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 in 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), 2 (Buy), 3 (Hold) (whether good market conditions or bad, stocks with a Zacks Rank #1, #2 or #3 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 or 2 offer the best upside potential.
Here are five of the 13 stocks that qualified the screening:
Smith & Wesson Holding Corporation (SWHC - Free Report) : This is a provider of quality products for shooting, hunting, and rugged outdoor enthusiasts in the global consumer and professional markets. The company reports under two segments, Firearms and Outdoor Products & Accessories. This stock can be an impressive value investment pick with its Zacks Rank #1 and Value Style Score ‘A’. Apart from a discounted PEG and P/E, the stock also has an impressive expected five-year growth rate of 10%.
Guess', Inc. (GES - Free Report) : This company is a renowned designer, marketer and distributor of lifestyle collections of casual apparel and accessories for men, women and children matching American lifestyle and European fashion sensibilities. The stock currently carries a Zacks Rank #3 and a Value Style Score ‘A’. The company also has an impressive expected five-year growth rate of 16.3%.
Nippon Telegraph and Telephone Corporation (NTT - Free Report) : This popular name in the field of mobile voice related services, IP/packet communications services, telecommunication equipment, system integration, and other telecommunications-related services has a Value Style score ‘A’. The company also has an impressive expected five-year growth rate of 9.5%. It carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.
NTT DOCOMO, Inc. (DCM - Free Report) : This company provides mobile telecommunications services in Japan. This Zacks Rank #2 and Value Style Score ‘B’ company also has an impressive expected five-year growth rate of 23.4%.
Western Refining, Inc. (WNR - Free Report) : This is an independent crude oil refiner and marketer of refined products. This stock can also be an impressive value investment pick with its Zacks Rank #3 and Value Style Score ‘A’. The company’s five-year historical earnings growth rate stands at 42.9%.
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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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