Investors are faced with a mountain of information, strategies and tactics to choose from. Value, growth, momentum, options, futures… which strategy is right for you?
While every strategy has their pros and cons, one of the better-performing strategies has come from focusing on growth stocks. Growth stocks have certainly done well over the last decade, outpacing the popular value approach over that time period. But that doesn’t mean we should ignore value.
In fact, long-term studies still suggest that following a disciplined contrarian, value-driven strategy is the best path to success. Value investors argue that while the market may be efficient in the long term, emotions often dominate in the short run. These emotions can overtake rational analysis, pushing a stock's price above its intrinsic value during periods of euphoria and below its true worth when reacting to bad news.
Value screens, such as searching for stocks with a low price-earnings ratio, typically look for low prices relative to actual measures of company performance or assets. The price-earnings ratio, or multiple, is computed by dividing a stock's price by its most recent 12 months' earnings per share. The price-earnings ratio is followed closely because it embodies the market's expectations of future company performance and risk through the price component of the ratio and relates it to historical company performance as measured by earnings per share.
A simple search for low price-earnings ratios, however, can be misleading as it may leave you with a list of companies with little or no growth prospects, or uncertainty regarding the future of the firm. For instance, retailer Macy's (NYSE: M) has a P/E ratio of just 6.3x. While that's extremely cheap when compared with the S&P 500's P/E of 22, most analysts agree that Macy's is facing some strong headwinds.
But a popular metric -- and one that forms the basis of today's screen -- is to use a multiple that seeks to combine value and growth to identify companies trading at a discount to their future growth.
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P/E to Earnings Growth: The PEG Ratio
This popular ratio is used to find both value and growth. It involves identifying stocks with low price-earnings relative to earnings growth. The P/E to growth ratio (PEG ratio) is computed by dividing the price-earnings ratio by its future earnings growth rate. Ratios below 1 indicate that a stock may be undervalued, while stocks with ratios above one may be overvalued. The idea is to purchase a stock with some demonstrated earnings growth before the market recognizes the company's potential and bids up the price-earnings ratio.
Typically, firms with high growth potential trade with correspondingly high price-earnings ratios, while those with low price-earnings ratios are expected to have low growth or high risk. Again, screening just for stocks with a low price-earnings ratio may leave you with a list of companies with little or no growth prospects or great uncertainty regarding the prospects of the firm. Screening for high P/E stocks is not the answer either. While firms with high P/E ratios normally have everything going for them now, you don't want to overpay for future earnings. This is where the PEG ratio comes in. It helps investors judge whether the market is overpaying for these stocks, or whether that future growth is being discounted at current prices.
The one major caveat of the PEG ratio is that it uses future projections. And like the weather, those can be hard to predict. If expectations of earnings growth are too lofty and the company can't fulfill those expectations, then it can lead to a quick and sudden drop in share price. However, on the flip side, if the company beats those expectations, you might see a sudden surge in share price as expectations are re-adjusted.
You might see different PEG ratios from different financials outlets, as one analyst might use data from, say, Thomson Reuters, while another uses Bloomberg data, and another yet uses FactSet. For this screen, the earnings estimates are pulled from the Institutional Brokers' Estimate System (IBES), which is maintained by Thomson Reuters. This screen is an equity-only screen, meaning it doesn't include mutual funds, exchange-traded funds (ETFs) or bonds.
I wanted to find stocks that have a PEG ratio less than or equal to one -- which indicates the stock is undervalued relative to its estimated earnings growth. Only 16 stocks made the cut…
One company that stands out is NVR, Inc. (NYSE: NVR). This was a company I highlighted in my annual report "The Top 10 Stocks for 2019." I believed that the homebuilder would be a good bet for 2019, and so far it's done very well. It's up roughly 40% year-to-date, yet according to its PEG ratio, the stock is still a good bet.
Seven of the 16 stocks come from the financial industry -- an industry that's been discounted since the financial crisis in 2008. From this list, I like life-insurer Primerica (NYSE: PRI) and investment and financial advisory platform LPL Financial (Nasdaq: LPL).
Both companies not only sport good PEG ratios, but they gush free cash flow (in Primerica's case, it generated $465 million in 2018, and has grown that figure at an incredible 23.2% average annual clip over the last five years). As for LPL Financial, it churned out $421 million in free cash flow last year and grown it an average annual pace of 38.7% over the past five years.
As with any metric, the PEG ratio shouldn’t be used on a standalone basis, but it can provide a good starting point for further research, especially when looking for value and growth.