Value investing is gaining popularity by the day. The success of value investors like Warren Buffett further underscores this.
However, 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 earnings growth potential of a stock.
However, at a time when volatility strikes every second day, it is pointless to ponder on methods which don’t take a stock’s future growth rate into consideration while calculating its intrinsic merit. Yardsticks such as dividend yield, P/E or P/B are most commonly used to single out stocks that are trading at a discount.
However, these ratios, while not taking into account the growth potential of a stock, may end up convincing us to invest in stocks that are at a discount just because of their poor show. This may often lead to “value traps” — a situation when these value picks start to underperform over the long run as the temporary problems, which once affected 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 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 determine the intrinsic value of a stock.
There are some drawbacks of 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 the screening criteria for a winning strategy:
PEG Ratio less than X Industry Median
P/E Ratio (using F1) less than M 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 four stocks that qualified the screening:
RH (RH - Free Report) : It is a curator of design, taste and style in the luxury lifestyle market. The company offers collections through its retail galleries, Source Books and online. RH can be an impressive value investment pick with its Zacks Rank #1 and Value Style Score of B. The company’s long-term expected earnings growth rate is 30%.
Lakeland Industries, Inc. (LAKE - Free Report) : The company manufactures and sells a comprehensive line of safety garments and accessories for the industrial protective clothing market. Apart from a Zacks Rank #2 and a Value Style Score of A, the stock has an impressive long-term historical growth rate of 62.5%.
Zumiez Inc. (ZUMZ - Free Report) : Zumiez is a leading specialty retailer of apparel, footwear, accessories and durable goods for young men and women who want to express their individuality through fashion, music, art and culture of action sports, streetwear, and in other forms. The stock also can be an impressive value investment pick with its Zacks Rank #1 and Value Style Score of A. Apart from a discounted PEG and P/E, the stock has a stellar long-term expected growth rate of 18%.
Verint Systems Inc. (VRNT - Free Report) : This is a leading global player in Actionable Intelligence solutions with a focus on customer engagement optimization, security intelligence, and fraud, risk and compliance. The stock has an impressive long-term expected growth rate of 10%. It has a Value Style Score of B and carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
The Research Wizard is a great place to begin. It's easy to use. Everything is in plain language. And it's very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out.
Click here to sign up for a free trial to the Research Wizard today.
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.