Value investing is gaining popularity by the day. The success of value investors like Warren Buffett further underscores this. Buffett and his business partner, Charlie Munger, managed to register 20.3% compound annual growth in the market value of Berkshire Hathaway from 1965 through 2019 as compared with the 10% gain 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 four stocks that qualified the screening:
McKesson Corporation MCK: In recent times, this health care services and information technology company is emphasising on a multi-year strategic growth initiative, focused on creating innovative solutions that improve patient-care delivery and boost profit growth. The company is also actively pursuing deals, divestitures and acquisitions in a bid to fuel growth. McKesson has an impressive long-term historical growth rate of 9%. The stock currently carries a Zacks Rank of 2 and has a Value Score of A. You can see the complete list of today’s Zacks #1 Rank stocks here.
United Therapeutics UTHR: Demand for United Therapeutics’ treprostinil medicines — Remodulin, Tyvaso and Orenitram — has been consistently growing despite generic concerns and competitive pressure. This therapeutic drug maker is working on new delivery mechanisms for Remodulin, and extended indications for Orenitram and Tyvaso, which are anticipated to bolster long-term growth. The company currently holds a Zacks Rank #2 and has a Value Score of A. It also has an impressive five-year historical growth rate of 20.9%.
Virtusa Corporation VRTU: It is a global provider of digital business strategy, digital engineering, and information technology (IT) services and solutions that help clients change, disrupt, and unlock new value through innovation engineering. Currently, the company is capitalizing well on the trend of growing worldwide demand for digital and cloud transformation. Apart from a discounted PEG and P/E, the stock currently sports a Zacks Rank #1 and has a Value Score of B.
Cardinal Health, Inc. CAH is a nation-wide drug distributor and provider of services to pharmacies, healthcare providers and manufacturers. The company has an impressive growth rate of 6.2% for the next five years. The stock currently has a Value Score of A and carries a Zacks Rank of 2.
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