Value investing is gaining popularity by the day. The success of value investors like Warren Buffett further underscores this. According to an article by Rajiv Bhuva, Buffett and his business partner Charlie Munger managed to drive 20.9% compound annual growth in the market value of Berkshire Hathaway from 1965 to 2017. Book value per share witnessed CAGR of 19.1%, from $19 to $211,750, in these 53 years.
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, 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 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 to 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 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) 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 five of the 21 stocks that qualified the screening:
Hill-Rom Holdings, Inc. HRC: This global medical device company partners with health care providers to improve clinical and economic outcomes in five core areas: Advancing Mobility, Wound Care and Prevention, Clinical Workflow, Surgical Safety and Efficiency, and Respiratory Health. The company has an impressive long-term historical growth rate of 16.9%. The stock currently has a Value Score of B and a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here . Bed Bath & Beyond Inc. ( BBBY Quick Quote BBBY - Free Report) : This company is a leading operator of specialty retail stores in the United States and Canada. It is an omni-channel retailer, offering top-quality and differentiated products, services and solutions. The stock currently carries a Zacks Rank #2 and has a Value Score of A. The company also has an impressive long-term expected growth rate of 6.4%. The AES Corporation AES: Arlington, VA-based AES is a global power company. The company’s businesses are spread across 18 countries in five continents. Apart from a discounted PEG and P/E, the stock sports a Zacks Rank #1 and has a Value Score of B. Syneos Health, Inc. SYNH: Headquartered in Morrisville, NC, the company is a key global biopharmaceutical solutions company offering a broad range of clinical and commercial facilities. The company currently holds a Zacks Rank #2 and has a Value Score of B. The company also has an impressive expected five-year growth rate of 10.5%. CACI International Inc CACI: Based in Arlington, VA, CACI International delivers IT applications and infrastructure to improve communications and secure the integrity of information systems and networks, enhance data collection and analysis, and increase efficiency and mission effectiveness. The company holds a Zacks Rank #2 and has a Value Score of B. The stock also has an impressive earnings growth rate of 10% for the next five years.
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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 .