Ever wonder how the most successful investors do it, correctly
calling stock picks time and again?
They must know something you don't, you think, something that gives
them that extra edge. Well, you're right. And it's easier than you
One of the least discussed -- but most important -- tenets
ofinvesting is a handy acronym known asGARP , or Growth at a
Reasonable Price. That connotes a company with strongearnings
growth, but a share price that isn't very expensive. In fact,
there's even a handy way to find out if a stock is a true
GARPinvestment . With a bit of math and a little-known ratio, you
can come up with a figure that spells it out -- then you can invest
like the big boys.
That ratio is known as thePEG ratio, which is actually a pair of
ratios matched together -- the price/earnings ratio (P/E ) divided
by the earnings growth rate (
). The P/E ratio is a stock price divided by earnings per share.
You can use a prior year P/E (trailing 12 months) or a future year
P/E (forward). The earnings growth rate is the rate that annual
earnings are growing, on a percentage basis, from one year to the
To understand, let's look at two companies, Tortoise Corp. and Hare
Industries. Tortoise manages to grow at a modest pace every year
while Hare is in the midst of much more robust growth.
While both of these companies earned $2 a share last year, the
profits of Hare are growing so quickly that they are likely to be
vastly higher in several years, perhaps exceeding $3 a share.
Tortoise, with its more dowdyprofit growth rate, likelywill earn
only $2.25 or $2.50 a share in several years.
In this example, Hare Industries is actually the better bargain,
despite the much higher P/E ratio. That's because its PEG ratio is
more attractive. In this instance, the PEG ratio for Hare
Industries is 0.8 (or 20 / 25). For Tortoise Corp., the figure is
1.33 (8 / 6). When it comes to PEG ratios, the lower the better.
In fact, you really want to focus your stock research on companies
that can first show that they have a PEG ratio below 1.0. In
effect, the P/E ratio should always be lower than the earnings
Exceptions to the rule
There are a few notable exceptions to this rule. A handful of
companies possess real strengths that you can't simply measure on
anincome statement . These are intangibles, such as a company's
brand, that can be worth as much as a company's income streams.
as an example. The beverage maker earned $1.28 a share in 2007 and
is expected to earn around $2.20 a share in 2013. That works out to
be around 10% annual earnings per share growth. Yet Coke'sshares
have always sported a forward P/E ratio of around 15 or 16,
equating to a PEG ratio of around 1.5. Why the premium valuation?
Because Coke's brands are so powerful that they are worth billions
of dollars by themselves, regardless of the actual earnings they
Other powerful brands that traditionally merit such a premium
American Express (NYSE:
. Yet these are exceptions to the rule. Most stocks are judged by
the PEG ratio. Perhaps not explicitly, but investors tend to
consider only stocks that look like a solid bargain in relation to
their earnings growth rate.
No profits? Look to the future.
Of course, many young and growing companies don't yet possess
robust earnings streams and thus sport very high P/E ratios and
therefore very high PEG ratios. For these companies, you'll have to
do some basic math to develop a sense of what the company's profits
will look like well down the road. For example, software provider
seems quite expensive right now, with 2013 earnings projected to
grow 33% to around $2 a share, while the forward P/Emultiple is 83.
That works out to be a PEG ratio of 2.5.
Yet analysts have looked out several years and figured that this
company's earnings per share could approach $4 by mid-decade.
Still, the stock trades at more than 40 times that figure, implying
a PEG ratio still above 1.0 (40 / 33). (Note that P/E ratios can be
applied to past or future earnings.) So it's hard tocall this stock
a bargain, now nor in the future.
Salesforce.com highlights ones of the biggest risks facing
investors. They often bid shares of a hot company such as
Chipotle Mexican Grill (NYSE:
up to nosebleed heights simply because it appears these companies
can do no wrong. When they do finally stumble, investors suddenly
takenote of a very high PEG ratio and toss these stocks aside. It's
no coincidence that both Netflix and Chipotle eventually tumbled by
more than $100 once their momentum faded. History says beware of
companies that can't deliver a healthy PEG.
Action to Take -->
As we enter 2013, conduct a PEG ratio analysis on your favorite
stocks. In coming weeks, analysts willissue their first estimate of
what 2014 profits will look like for the companies they cover. That
will help lay out a natural progression from 2011 and 2012
historical profits to the projected profits of 2013 and 2014. You
can gauge the rate of earnings growth and then see how that
compares to the P/E ratio. Any stock that sports a PEG ratio below
1.0 is worthy of further research.
-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC owns
shares of VZ in one or more of its "real money" portfolios.
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