The PEG Ratio
Two High-Quality Companies
How to Calculate PEG Ratios
A sure-fire method to find stocks that will outperform the
stock market during the next year or two is to ferret out
high-quality stocks with low PEG (price to earnings growth)
ratios. Many of you know how to calculate PEG ratios, but if you
need to review the several ways to compute this important ratio,
read my July 26, 2012
Cabot Wealth Advisory
to refresh your memory.
The PEG Ratio
I determine PEG ratios using the following method because it
brings the dividend into play. First, let's look at the
ingredients. The inputs are simple: the current stock price of a
), the latest four quarters of earnings per share (
), an estimate of how fast earnings per share will grow during
the next five years (
), and finally the latest quarterly dividend.
The next step is to calculate the price to earnings ratio
(P/E) by dividing the current stock price (
) by the latest four quarters of earnings per share (
). Then the latest quarterly dividend is multiplied by four to
convert the quarterly amount to the annual dividend (
), and D is then added to the five-year EPS growth estimate (
). Finally, the P/E ratio is divided by the combined Growth and
Dividend to determine the PEG ratio.
How to Become an Intelligent Investor
Many investors do not include the dividend in the PEG ratio,
but I believe my calculation is an excellent method to compare
companies paying higher than average dividends. Maybe I should
call it the PEGnD ratio--to be used only by intelligent
If you are using Microsoft Excel spreadsheets or similar
spreadsheets, this following formula will compute the PEGnD
In addition to low PEGnD ratios (below 1.00), I look for good
quality companies with a history of steady earnings and dividends
growth. Quality companies may not be extreme bargains, but
high-quality companies will likely produce reliable dividend
income and price appreciation.
How to find High-Quality Companies
A very simple measure can be used to determine which companies
are high quality and have produced steady earnings and dividend
performance during the past five to 10 years. Standard &
Poor's evaluates most stocks and assigns a ranking called the
S&P Quality Ranking.
Companies with A+, A, and A- S&P rankings indicate
high-quality. I generally like to find companies with these
rankings, although I will often include a company with a B+
ranking or occasionally a B ranking, if I believe the company has
exceptional prospects. S&P rankings are usually provided on
your broker's website. Just go to the stock research tab and
enter S&P in the search box.
Since April 2005, I have recommended companies with high
S&P Rankings and low PEG ratios every six months in the Cabot
Benjamin Graham Value Letter. My recommendations have increased
41% compared to an advance of 27% for the Standard & Poor's
500 Index during the same period through February 11, 2013.
This Cabot Wealth Advisory is a follow-up to my Advisory
featuring Low PEG ratios written on July 26, 2012. At that time I
recommended buying Aflac (
) and Reliance Steel (RS) which had low PEGnD ratios. During the
past six months, AFL and RS have increased 20% and 47%
respectively while the Standard & Poor's 500 Index has
increased only 12%.
High-quality stocks with low PEGnD ratios have consistently
outperformed the stock market indexes in both advancing and
declining markets. Investing in quality stocks at bargain prices
makes sense in any stock market environment.
Two good examples of high-quality companies with low PEGnD
ratios are Microsoft (MSFT) and Prudential Financial (PRU). The
companies have S&P Quality Rankings of B+ or better and their
PEGnD ratios are less than 1.00. And the companies have another
great attribute; they pay dividends yielding roughly 3%.
, the world's largest software company, develops, manufactures
and licenses software products and services for different types
of computing devices. Computer software includes the Windows
operating system, the Office application suite and cloud
computing services. The company also designs and sells hardware,
including entertainment products, digital music devices and
personal computer products.
Microsoft's new Windows 8 operating system designed for
computers, smartphones, and tablets is enjoying strong demand
from users. In addition, Microsoft's new tablet computer, called
the Surface, has won high praise for its innovative features. The
company controls the design, manufacture and marketing of Surface
in an attempt to compete head-on with Apple, which controls the
design, manufacture and marketing of its products.
Xbox consoles and Kinect movement games continue to gain
market share. Microsoft's Skype voice over Internet protocol
service (VoIP), acquired in May 2011, is providing rapid
I forecast 15% sales and EPS growth during the next 12 months
ending 12/31/13. The company could beat my forecast if new
products, such as the Surface, exceed expectations.
At 10.6 times latest EPS of 2.61, MSFT shares are way
undervalued. Microsoft pays a generous dividend yielding 3.3%. I
have calculated the PEG ratio at an attractive 0.75, based upon
the 10.6 price to earnings ratio, expected 11.0% EPS growth, and
3.3% dividend yield: well below my maximum limit of 1.00. Buy
Prudential Financial (PRU)
, a financial services leader with approximately $1.06 trillion
of assets under management as of December 31, 2012, has
operations in the U.S., Asia, Europe and Latin America.
Prudential offers investment management, group insurance and
other financial services in the U.S., and life insurance
Sales moved up sharply in 2012 as a result of acquisitions and
two new major contracts for pension services. Acquisition costs,
sluggish growth in the insurance business, and higher claims in
the disability business caused earnings per share to slip 5%.
Prudential has a lot going for it in 2013. The acquisitions
and new contracts will add considerable sales and earnings.
Higher assets under management and increased pricing in the
annuities business will add profits. The investment management
business in the U.S. and insurance sales overseas will also
provide a boost in 2013.
My forecast includes an earnings per share increase of 23% to
7.55 in 2013. From 2002 through 2012, Prudential shares paid an
annual dividend. Starting in 2013, the company will pay dividends
quarterly in March, June, September and December. Prudential will
likely hike the dividend from an annual rate of 1.60 in 2012 to
1.80 in 2013.
At 9.3 times latest earnings per share, and with a dividend
yield of 2.8%, PRU shares are clearly undervalued. I have
calculated the PEG ratio at an attractive 0.82, based upon the
9.3 price to earnings ratio, expected 8.5% EPS growth and 2.8%
dividend yield--well below my maximum limit of 1.00. In addition,
I believe the initial quarterly dividend will provide a yield of
more than 3% in 2013. Buy PRU now.
Until next time - be kind and friendly to everyone you
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