Forty thousand-plus people flocked to Omaha, Neb., the first weekend of May for Berkshire Hathaway's (NYSE: BRK-B) 50th-anniversary shareholder meeting.
Along with many of my peers, I always spend a good deal of time dissecting what Warren Buffett says at these annual meetings. And one of the things I gleaned from this year's event is that the Oracle of Omaha values stocks based on dynamic variables.
Buffett appeared on CNBC's "Squawk Box" the Monday after the meeting. When asked about whether stocks are overvalued, he told co-anchor Becky Quick that stocks look cheap as long as interest rates remain low. He added, "If interest rates normalize, we'll look back and say stocks weren't so cheap."
This indicates Buffett values stocks based partly on interest rates. It also signals he is willing to pay more for a company when rates are low, and that companies deserve lower valuations when rates rise.
The PEG ratio compares the price-to-earnings (P/E) ratio to the growth rate of earnings per share (EPS). A stock is considered fairly valued when the PEG ratio is equal to 1, which means the P/E ratio equals the EPS growth rate.
With other popular valuation models like the P/E ratio and price-to-sales (P/S) ratio, we can only compare one stock to another, or see if it's undervalued compared to its sector or the broader market. But that doesn't really tell us whether a stock is actually undervalued; it only tells us whether that stock is undervalued compared to something else. Both stocks could potentially be overvalued, one just less so than the other.
The PEG ratio recognizes that stocks with different EPS growth rates should trade with different P/E ratios. A stock growing earnings at 40% a year deserves to trade with a higher P/E than a stock with expected earnings growth of just 5% a year. The PEG ratio adapts to the company's fundamentals, which makes it more useful than the more common "one size fits all" valuation approaches, such as buying when the P/E ratio is below some arbitrary number.
Let's take a look at a stock that is insanely undervalued by this measure, United Continental Holdings (NYSE: UAL).
Over the past five years, the company's EPS growth averaged 7.6%. But in the next five years, analysts estimate growth will average 36.6% a year. That is nearly five times as much, and will likely be the result of industry consolidation, increased revenue from service fees, lower fuel prices and upgrades to more fuel-efficient aircraft.
According to the PEG ratio, if we use the expected EPS growth rate of 36.6% for our P/E multiple and expected 2015 EPS of $10.88, UAL could be worth as much as $398 a share. The current price is about one-sixth of that amount.
Even by more conservative measures -- for example, subbing in the airline industry's five-year average P/E ratio of 17.6 and estimated 2016 earnings of $9.27 -- UAL would be worth about $163 a share, more than 2.5 times the current price.
More Than One Way to Buy a Value Stock
UAL is basically a value investor's dream and could easily be considered a "buy" by most. But rather than buy shares, I take a different approach. I sell put options.
Now wait, before you quit reading, know that the world's most famous value investor, none other than Warren Buffett himself, also uses this strategy as a way to buy stocks he likes at a discount.
When you sell a put option, you select the price you are willing to buy shares at. This is the option's strike price. When you sell that put option, the buyer pays you cash, known as premium. In return, you are now obligated to purchase shares if they are below the level you have already determined you are willing to pay for them when the option expires. And, in fact, since you collected the premium, you can subtract that amount from the strike price to get your actual cost basis, meaning you get an even bigger discount.
I'll show you how this works using UAL as an example. Last week, UAL was trading around $59.30, and I told readers of my Income Trader service to sell UAL put options with a $52.50 strike price that expired in June. This brought in income of $0.72 per share ($72 per option contract, which controls 100 shares).
So if UAL is below $52.50 on June 19, the last day these options can be traded, we will take ownership of shares at that price. But when you include the $0.72 we received for selling the put, our cost basis is lowered to $51.78, which was a 13% discount to where the already severely undervalued UAL was trading at the time.
In truth, while I only sell puts on stocks I want to own at a discount, nine times out of 10 the put options I recommend expire worthless. This means that the income we collected is ours to keep free and clear with no further obligation. And if we choose, we can sell another put at a later expiration date, bringing in more income and getting another chance to buy shares at a lower price.
Case in point, I first identified UAL as a deep bargain in April 2014, and since that time we've sold three put options on the airline company that expired worthless:
So with last's week trade, those who sold just one of each contract have collected a total of $300 on UAL without ever paying a cent for shares. Those results are fully scalable. Anyone who sold five of each contract has brought in $1,500. They would have made $3,000 on 10 contracts or $6,000 on 20 -- you get the picture.
Last week's trade is already moving in our favor, with UAL now nearly 17% above the put's strike price. This is great news, but it also means the risk/reward is out of balance for new traders. I always tell my readers to use limit orders to ensure they get the desired level of income and to never chase a trade. There will always be another opportunity to generate income selling puts.
If you're interested in learning more about how put selling works, I've put together a free eight-minute tutorial. You can also sign up to get trades like this each week, and start collecting hundreds of dollars by next week by following this link.
This article was originally published on ProfitableTrading.com: This May be One of the Most Undervalued Stocks in the Market