There are only three letters that investors need to know to be
able to find stocks that have the potential for big gains.
Those letters are P, E, and G. Combine these and you get PEG, an
acronym for the most simple and powerful stock analysis metric for
identifying growth stocks today.
, I devoted a chapter in my book,
Financial Projections and Valuations
to the PEG ratio.
The simplicity of this ratio is what makes it so useful for
identifying small cap growth stocks
***PEG calculates the P/E ratio of a stock in comparison to the
growth rate of the company. The calculation allows you to determine
the valuation of the company relative to its growth rate. PEG is an
important measure because it allows us to understand the value that
is being placed on the company's financial growth. I look for low
PEG ratios - the lower the better. A PEG ratio equal to 1.0 is
often considered a fair value. What this means is that companies
whose stocks have a PEG below 1.0 may be undervalued, and those
above 1.0 overvalued.
Earnings estimates typically cover a period between three months
to one year. In my opinion, estimates that extend past a year
should be practically ignored. It is difficult to have realistic
longer-term estimates for a businesses performance, and this is
particularly the case for small cap stocks where their products,
partnerships, and marketing can change dramatically in a short
period of time. That being said, strong financial performance over
the long-term can point to high quality companies with good
leadership at the helm.
I typically look for small cap companies that are reporting
revenue and earnings growth of at least 20 percent per year. These
are the companies that I have found to have the greatest profit
potential for their shareholders. They often have a higher
probability long-term success, and this often equates to
significant capital gains.
Take for instance Real Goods Solar, Inc. (Nasdaq: RSOL), one of
the premiere makers of solar panels for homes and businesses. They
sold the first retail solar panel over 30 years ago and have not
looked back since. Analysts estimate that Real Solar revenues for
the coming year will increase 27 percent. With a healthy
expectation for revenue growth, it's worth looking into the
valuation of the company.
When beginning a search for high quality but reasonably priced
small cap stocks, I start by looking at most popular tried and true
metric - the price-to-earnings (P/E) ratio. The ratio is calculated
by taking the share price of the stock divided by the
Taking a look at Real Goods Solar, I see that the stock has
forward P/E ratio of 18.4, based on it's share price of $2.45 and
2011 EPS estimates of $0.13. This PE is slightly below the peer
group with an average forward P/E of 20.3. The stock has a PEG
ratio of 0.32 based on the blended growth rate for 2011. The
blended growth rate is just the average of the revenue and EPS
growth rates from 2010-2011 Real Goods Solar fall below 1.0 which
means they are most likely undervalued.
So based on the initial growth screen Real Solar passes the
first test. For the small cap investor, this is a great starting
point to learn more about this company by asking questions about
the company's long-term growth, prospects for expansion, and the
value of its shares. Let's look at the growth rates to see if the
company could be in the early stages of rapid growth.
I will be back next week to discuss my next steps in completing
more thorough research and analysis of Real Goods Solar.