It's one of the first rules of investing: find stocks with
strongearnings growth and reasonable valuations. We're even taught
a simple formula: look for stocks that have a price-to-earnings
(P/E ) ratio that is lower than theearnings growth rate, or, a
ratio (P/E divided by theearnings growth rate) lower than 1.0.
Yet the converse is also true. Stocks with a PEG ratio over 1.0 can
beovervalued . It happens without many investors even noticing. A
stock rises and rises until its value becomes disconnected from the
reality on the ground. A high PEG ratio can limit further upside
and make a stock especially ripe for a pullback in down markets. On
the flip side, it can also make for a nice stock to short.
Here's a look at three stocks with alarmingly high PEG ratios. Each
of the stocks on this table trade at least 50% abovefair value when
the PEG ratio test is applied.
Salesforce.com (Nasdaq: CRM)
This provider of contact relationship software has seen itsshares
fall roughly 10% since I profiled it two months ago. Yetshares
still look really expensive. If you assume that the company can
boost profits by 20% every year, it would take eight years for
theP/E ratio to fall down to theearnings growth rate -- assuming
the stock went nowhere in that time.
Salesforce's bulls are counting on the company's current
initiatives to help set the stage for accelerating growth. But
they're ignoring "the laws of big-ness." As a company gets larger,
it gets harder and harder to maintain aggressive growth rates. Just
eBay (Nasdaq: EBAY)
. Years of torrid growth have been replaced by ever-slowing growth
for those firms. That may not happen for Salesforce.com in 2011 or
2012, but counting on nearly a decade of very strong growth yet to
come seems foolhardy.
Ceva (Nasdaq: CEVA)
During the prior seven years, this chip designer mostly traded in
the single digits. But in the past two years, it has risen roughly
300% to a recent $24. Why the breakout? Its chips (and licensed
designs) are finding their way into an increasing number of smart
phones. The company toiled for years to get other chip makers to
use its technology and had a banner year in 2010, currently
counting 34 licensees for its communications-based intellectual
Yet investors are likely getting carried away, pushingshares up to
more than 40 times projected 2011 profits and about 30 times likely
2012 per share profits of $0.80. Many are mistakenly viewing Ceva
as being on the cusp of a sustained long-term expansion. But this
industry is characterized by an ever-changing landscape of winners
and losers. Momentum in any given year is eventually lost as rivals
steal backmarket share . For example, Ceva saw sales nearly double
in 2003 to $36 million, yet by 2009, they were still below $40
Sales now look headed up again to $60 million by next year thanks
to recent design win momentum, but are likely to hit a cyclical
peak at that point. Indeed rivals such as Taiwan's MediaTek are
pushing back with their own design upgrades while also maintaining
lower licensing price points. There's no reason to expect Ceva to
see sales and profits slump, but long-term growth also appears
deceivingly robust. When reality sets in, sharers are more likely
to generate a mid-teens multiple, pushing
back down toward the $15 mark.
Sears Holdings (Nasdaq: SHLD)
Most of the companies on the table above can at least boast of
near-term solid growth prospects. But this retailer looks to be
going the opposite way, heading into a long-term secular decline.
Management has been much more focused on financial maneuverings
such as stock buybacks than in keeping stores fresh and
competitive. The Kmart division looks especially weak, as its
stores haven't been upgraded for quite some time.
Shoppers are voting with their feet. Sales are on track to fall for
the fourth straight year in thefiscal year that ends this week.
Analysts expect sales to fall yet again in the comingfiscal year .
That's why the equivalent of 10 days worth of daily trading volume
is held in short positions.
Yet the company has its supporters. Sears has been buying back so
much stock that shares outstanding have fallen from 155 million in
2007 to a current 110 million. Were it not for buybacks, per share
profits would be falling even faster than the 12% decline currently
forecasted for the comingfiscal year . Nevertheless, profits that
are falling faster than sales are a sure sign that a retailer is
struggling with the negative effects of
As long as management allows the store base to languish, further
sales erosion appears inevitable. Profit weakness could be even
more profound. So why are shares trading for 66 times projected
(January) 2012 profits? The reasons are unclear to me. Goldman
Sachs predicts shares will fall from a current $75 to around $54 as
the company's dismal long-term outlook comes into sharper focus.
UBS is slightly more charitable with a $56 price target, predicting
bad news ahead: "Sears could see a return to high single-digit
negative comps beginning in the (first quarter) through (the second
quarter) as the company begins to lap the appliance stimulus
benefit of last year."
Action to Take -->
Investors tend to fixate on near-term trends. But you need to
understand how the future will play out in order to stay ahead of
the crowd. In the instances noted above, the long-term view doesn't
remotely justify the near-term
ratios. Any one of these stocks could make for a ripe short
-- David Sterman
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Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.