# Investing 101: Stocks Highly Undervalued By PEG, Free Cash Flow, and the Graham Number

**By:**Kapitall

**Posted:**7/21/2011 5:57:00 PM

**Referenced Stocks:**DFG;ETM;GTS;HRBN;LHCG;LTXC;MKSI;MS;RSH;STZ

(*List compiled by Becca Lipman*)

For this list we wanted to find companies that appear undervalued by 3 different metrics: relative to earnings growth (with PEG under 1), undervalued relative to free cash flow (with P/FCF under 10), and undervalued by the Graham number (which accounts for earnings per share and current book value).

Confused by any of these terms? Let’s review what they mean and why they are helpful tools in finding potentially undervalued stocks:

We start with **Earnings Per Share (EPS).** EPS is the amount of profit that is allotted to each share of a company after dividends have been paid out. Higher EPS and faster EPS growth are both positive signs of profitability.

EPS = (Net Income - Dividends)/(Outstanding Shares)

We move on to the **Price to Earnings Growth Ratio (PEG).**

To understand PEG, we start with the **Price/Earnings ratio (P/E)**, a widely-used tool for valuing a stock. P/E is short for the share price relative to earnings per share (EPS). The ratio indicates how much investors are paying for a dollar of earnings.

P/E = (Share Price)/(EPS)

It is important to remember that share prices take into account expected future earnings growth. So investors might be willing to pay a high price today if they expect a company's earnings to grow significantly in the future. This makes comparing P/E ratios complicated -- some industries have high earnings growth trends, which inflates a company's P/E relative to companies in other industries.

This is where PEG ratios become handy. PEG is short for the Price/Earnings to Growth ratio. The PEG ratio takes the P/E ratio one step further by including a calculation for annual earnings (EPS) growth.

PEG = (P/E)/(Annual EPS Growth)

In general, a stock with a high PEG ratio is considered expensive or overvalued, while a stock with a low PEG ratio is considered cheap or undervalued. *In this article we investigate stocks with PEG ratios under 1.*

The second way that we searched for undervalued stocks is with the **Price to Free Cash Flow Ratio (P/FCF).**

Free cash flow is the amount of cash generated by a company in one year after subtracting short-term and long-term investments in the company, expenses, and taxes. It is the cash flow available to both debt and stock investors. The ratio of stock price divided by free cash flow per share (P/FCF) is often used to compare the value of companies. As a general rule, P/FCF under 5 (or price is less than 5 times free cash flow per share) is considered “undervalued,” which means the stock may be trading at too low of a price and may rise in the future to properly reflect the free cash flow generated by the firm.

*For this article we investigate stocks with P/FCF ratios below 10.*

Lastly, we looked for stocks undervalued by the **Graham Number.**

According to Benjamin Graham, a former mentor of Warren Buffett and the so-called “Godfather” of value investing, the Graham Number is the maximum price that a value investor should pay for a given stock. A stock whose share price is below the Graham Number is considered to be undervalued or of good value.

It is a calculation for the fair-value price of a stock based on its earnings per share (EPS) and most recent quarter’s book value per share (the value of the company's assets divided by the number of shares).

The Graham Number = Square Root of (22.5) x (TTM EPS) x (MRQ Book Value per Share).

We use **Trailing Twelve Month (TTM)** diluted EPS. Trailing twelve months (TTM) is an indication that the calculated data has come from the last twelve months.

*For this article we took stocks undervalued to the Graham number by more than 30%.*

The following names are undervalued by all three metrics. Our list is sorted by potential upside as calculated by the Graham number. Do you feel these companies are truely undervalued? Use the list as a starting-off point for your own analysis.

Without further ado:

*Analyze These Ideas (Tools Will Open In A New Window)*

1. Access a thorough description of all companies mentioned

2. Compare analyst ratings for all stocks mentioned below

3. Visualize annual returns for all stocks mentioned* 1. Morgan Stanley (MS):* Investment Brokerage Industry. Market cap of $32.49B. PEG at 0.85. P/FCF at 2.13. TTM diluted EPS at $2.03, MRQ book value per share at $31.45, implies a Graham number of $37.9 (vs. current price of $21.61, a potential upside of 75.39%). The stock has lost 16.18% over the last year.

*Life Insurance Industry. Market cap of $1.60B. PEG at 0.95. P/FCF at 4.51. TTM diluted EPS at $3.34, MRQ book value per share at $29.13, implies a Graham number of $46.79 (vs. current price of $29.22, a potential upside of 60.12%). The stock has gained 26.77% over the last year.*

**2. Delphi Financial Group, Inc. (DFG):***Accident & Health Insurance Industry. Market cap of $680.57M. PEG at 0.99. P/FCF at 7.54. TTM diluted EPS at $2.26, MRQ book value per share at $21.68, implies a Graham number of $33.2 (vs. current price of $24.03, a potential upside of 38.17%). Exhibiting strong upside momentum--currently trading 6.87% above its SMA20, 11.26% above its SMA50, and 21.16% above its SMA200. The stock has had a good month, gaining 15.98%.*

**3. Triple-S Management Corporation (GTS):***Semiconductor Equipment & Materials Industry. Market cap of $409.12M. PEG at 0.42. P/FCF at 5.54. TTM diluted EPS at $1.23, MRQ book value per share at $4.59, implies a Graham number of $11.27 (vs. current price of $8.22, a potential upside of 37.11%). This is a risky stock that is significantly more volatile than the overall market (beta = 2.58). The stock has lost 0.6% over the last year.*

**4. LTX-Credence Corporation (LTXC):***Electronics Stores Industry. Market cap of $1.34B. PEG at 0.99. P/FCF at 9.06. TTM diluted EPS at $1.63, MRQ book value per share at $8.32, implies a Graham number of $17.47 (vs. current price of $12.82, a potential upside of 36.26%). The stock has lost 36.08% over the last year.*

**5. RadioShack Corp. (RSH):***Diversified Machinery Industry. Market cap of $1.34B. PEG at 0.46. P/FCF at 8.85. TTM diluted EPS at $2.95, MRQ book value per share at $17.45, implies a Graham number of $34.03 (vs. current price of $25.03, a potential upside of 35.97%). The stock has gained 28.57% over the last year.*

**6. MKS Instruments Inc. (MKSI):***Home Health Care Industry. Market cap of $412.05M. PEG at 0.57. P/FCF at 9.32. TTM diluted EPS at $2.46, MRQ book value per share at $15.42, implies a Graham number of $29.21 (vs. current price of $21.71, a potential upside of 34.57%). The stock is a short squeeze candidate, with a short float at 12.8% (equivalent to 12.97 days of average volume). It's been a rough couple of days for the stock, losing 5.36% over the last week.*

**7. LHC Group, Inc. (LHCG):***Broadcasting Industry. Market cap of $329.86M. PEG at 0.93. P/FCF at 4.1. TTM diluted EPS at $1.15, MRQ book value per share at $4.86, implies a Graham number of $11.21 (vs. current price of $8.35, a potential upside of 34.3%). This is a risky stock that is significantly more volatile than the overall market (beta = 2.69). The stock is a short squeeze candidate, with a short float at 13.38% (equivalent to 15.53 days of average volume). The stock has gained 5.92% over the last year.*

**8. Entercom Communications Corp. (ETM):***Industrial Electrical Equipment Industry. Market cap of $597.50M. PEG at 0.6. P/FCF at 9.15. TTM diluted EPS at $2.14, MRQ book value per share at $13.86, implies a Graham number of $25.83 (vs. current price of $19.25, a potential upside of 34.2%). This is a risky stock that is significantly more volatile than the overall market (beta = 2.18). The stock has had a couple of great days, gaining 9.89% over the last week.*

**9. Harbin Electric, Inc. (HRBN):***Beverages Industry. Market cap of $4.49B. PEG at 0.77. P/FCF at 6.27. TTM diluted EPS at $2.75, MRQ book value per share at $12.67, implies a Graham number of $28 (vs. current price of $20.94, a potential upside of 33.71%). The stock has gained 25.16% over the last year.*

**10. Constellation Brands Inc. (STZ):**

*Interactive Chart: Press Play to see how analyst ratings have changed for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research.*

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