In search of undervalued companies, investors seek out stocks
that tend to have anearnings growth rate that is higher than the
) ratio. These stocks are known as low
stocks, or stocks with a PEG ratio below 1. (For example, a P/E of
10, and an
growth rate of 20% yields a PEG ratio of 0.5, or 10 divided by 20).
Well, the converse is also true. Companies with a high PEG ratio
. If you hold a stock with high PEG ratio, you may want to
contemplate selling the shares. Better yet, high PEG stocks
sometimes also make compelling
So I went looking for companies that have a P/E ratio that is at
least twice as high as the earnings growth rate. In other words,
they have a PEG ratio above 2.0. On the table below, I've compiled
a list of high P/E stocks that show either small or negative profit
growth forecasts for 2011. For most on this list, profit growth is
expected to turn negative next year, but the basic concept of a
too-high PEG ratio still applies.
Akamai Technologies(Nasdaq: AKAM)
appears to be a poster child for high PEG stocks. The provider of
content delivery services is a good -- not great -- growth story.
Over the years, an increasing number of companies have relied on
Akamai to store content in local servers so websites can be pulled
up quickly anywhere in the world. After years of erratic growth,
the company is on track to boost sales and profits about +15% in
2011. Yet this has become a largely
, price pressures are starting to bite, and the major telecom
players are trying to steal
, which is why analysts don't expect profit growth to exceed +10%
to +15% in 2012 and beyond.
So why do shares trade for 33 times projected 2011 profits? Or said
another way, does this stock deserve a PEG ratio above 2.0?
Probably not. Instead, this is a classic example of a stock that
becomes so hot that it becomes disconnected from the fundamentals.
Investors have been bidding up shares in the expectation that a
suitor for the company might emerge. Yet the higher shares rise,
the harder it would become for a suitor to acquire the company
without taking a big hit to its
earnings per share (
, as any deal would likely be quite dilutive. So if a deal fails to
materialize, or investors start to see Akamai as a slowing-growth
kind of company, then the high P/E ratio would set shares up for a
It's worth adding that
Limelight Networks (Nasdaq: LLNW)
InterNAP (Nasdaq: INAP)
, a pair of Akamai rivals, also make this list. Each stock carries
a super-high P/E ratio, which would be understandable if each
company was just getting going. But this is a mature industry, and
these companies are likely to only grow in single digits in 2012
and beyond. So it's hard to see howearnings will grow fast enough
to ever justify such a lofty P/E ratio.
Theearnings look back
At first glance, it makes sense that boat builder
Marine Products (
sports a very high P/E ratio. Boat sales are depressed and profits
will be more robust when the
improves. Back in 2005, the company earned a record $0.65 a share,
and the stock trades for about 10 times that figure. But that was a
peak year. In the past 10 years, annual
has averaged $0.30. And shares don't deserve to trade at 20 times
average annual earnings, since this is a highly cyclical business.
This stock has nearly doubled since the summer of 2009, but it
looks as if investors are over-estimating the prospects of robust
profits in the future.
A high-growth P/E for a low-growth company
Perhaps no company on this list better typifies the perils of a
high PEG ratio than retailer
Sears Holdings (Nasdaq: SHLD)
. Profits are going nowhere, but you can't just blame the weak
economy. Management has spent the past five years squeezing cash
out of this business, leaving Sears and Kmart stores badly in need
of sprucing up. As analysts at research firm ISI noted in a recent
report, Sears Holdings generated no
free cash flow
in the first half of 2010, but still bought back $273 million in
stock. Their conclusion: "We continue to believe that
underinvestment will not support the asset base and find much
better opportunities (elsewhere) in retail." They see shares
falling from a recent $73 down to $52 as they predict that current
consensus profit forecasts are too high.
Analysts at UBS see shares falling down to $56 and rate the stock a
"sell." They have a point -- shares trade for more than 30 times
UBS's 2011 profit forecast.
Action to Take -->
The only time you can justify a high P/E ratio is when a company
has not begun to reap the benefits of projected strong growth. But
the companies on this list are largely mature, and unlikely to see
a big spurt in profits down the road. Sears Holdings in particular
carries the value of a hot tech stock but is really a lumbering
giant whose best days have passed. If you hold any of these stocks,
consider selling. And for those investors looking for a short
candidate, the list above is a good place to start.
-- David Sterman
David Sterman started his career in equity research at Smith
Barney, culminating in a position as Senior Analyst covering
European banks. David has also served as Director of Research at
Individual Investor and a Managing Editor at TheStreet.com. Read
P.S. -- Any analyst can tell you they like a stock. But how many
are willing to put their money where their mouth is?
StreetAuthority Market Advisor is so confident in Nathan
Slaughter's picks that we gave him $100,000 in cash to put into his
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Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.
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