Jordan Lai/Getty Images
How much are you paying to grow your earnings? PEG attempts to measure that. Super PEG is better.
William Baldwin, Senior Contributor
Growth is worth a premium on Wall Street, but it’s not just a premium. We need metrics to assess whether a company’s market value is out of sync with the earnings growth it can achieve. Our goal is to grow at a reasonable price.
Comparing PE (Price/Earnings) and G (Growth) gives you PEG. This is the classic formula for measuring the price tag of growth stocks. But PEG is deeply flawed. There is something better, here named Super PEG. “Super” does not mean that the new ratio is the final quantitative indicator, only that it replaces the flawed old ratio.
Using Super PEG, we spotlight 20 out-of-favour stocks that could be bargains if they can maintain their recent growth rates for a while. These include home builders, companies that sell socket sets, and truck dealers.
Then: A list of companies that look expensive with older PEGs, but appear to be worth a look with super PEGs. Junk food, swimming pools, and hardware are featured.
Classic PEG is simple. Hershey has a price-to-earnings ratio of 20 times and forward earnings growth of 5 times (in percentage points). Divide one number by the other to get the PEG of 4 shown on Yahoo Finance. By that standard, the confectionery maker’s stock is quite expensive. PEG enthusiasts like to see ratios below 1, such as companies trading at 15x P/E and growing earnings per share at a 15% clip.
When performing arithmetic using a slide rule, the advantage was that calculations were easy. Not now.
PEG has two flaws. One is that it assumes a linear relationship between growth rate and its outcomes. However, this is not how compound interest works. A decade of 30% growth will not generate three times as much revenue as a decade of 10% growth. You will get 5 times the amount.
Another issue where PEG gets it wrong has to do with dividends. A company with flat earnings and a 7% yield will provide shareholders with exactly the same amount of return as a company with earnings per share growing 7% and no dividends. PEG ignores dividends. The latter companies are doing well, but those who pay dividends don’t think they’re worth it.
Super PEG takes a completely different route to measuring the return on growth. It measures how much you are paying now to get a certain level of earning power in the future and compares it to the amount you are paying to get future earning power from the S&P 500 index. If you can buy future returns from a stock for half the price you would pay investing in the market average, then your super PEG is 0.5.
When is “Down the Road”? You can insert any period in the expression. The first list of undervalued stocks uses a very conservative five-year time horizon. It also assumes that the historically impressive growth will regress to the mean. More precisely, we start with the past 10 years’ EPS growth rate, let the target company continue at that growth rate for one year, and then reduce future growth rates to the market average over five years at the same step.
The historical growth rates shown here reflect the steepness of the exponential line fitted to the EPS record. How to do this is explained in “Market Lessons: Finding Fast and Steady Revenue Growth.” Dividends count toward future earning power growth as if they were used to purchase additional shares.
Below is a list of stocks whose stock prices are cheap compared to their future earnings expectations. This is limited to companies in the top quartile of historical earnings predictability.
Will all of these stocks outperform? Most likely. Super PEG and other metrics don’t tell you how to get rich. It just shows you which stocks Wall Street hates. The same goes for the most basic indicator, the price-to-earnings ratio. There is a reason for the low P/E ratio. We need to find out what the reasons are and whether they justify the market’s dissatisfaction. The same is true if your Super PEG is low.
Clearly, investors are skeptical about homebuilding. The Toll brothers, Dr. Horton and Renner are here. So does Owens Corning, which makes the pink insulation that’s stacked high at Home Depot.
Internal combustion engines have a bad reputation. That may explain the emergence of Penske Auto Group, which sells and services trucks. LKQ, which sells aftermarket repair parts, and Snap-on, which sells socket wrenches for mechanics. We may be entering a halcyon era of low-cost electric cars that don’t need repairs and don’t cause accidents. But if you doubt that this future is a long way off, you might prefer traditional companies in the automotive sector.
The following list highlights stocks that are priced high on super PEG terms. They are giving the benefit of the doubt by assuming 10 years of above-market growth.
Some of these fast-growing companies may confirm investor enthusiasm. But really. Is the restaurant chain’s profit 135 times? What do people do when they get tired of chicken wings?
Second, there are companies that are rated as high cost under the old PEG, but are rated from a different perspective under the super PEG. It’s easy to see what’s going on at Enterprise Products Partners, which handles crude oil. Midwest power company Evergy and junk food industry leader General Mills: Traditional PEG doesn’t handle dividends correctly.
This futurist list includes companies that have significantly increased their apparent value by phasing out superior growth over 10 years instead of 5. If you think their growth trajectory has lasting power, they’re a bargain.
Finally, there are speculative plays that are cheap relative to a strong but uneven earnings history.
Learn more about Forbes Forbes Market Lessons: Understanding price-earnings ratios — Hyun-Soo Lim with 12 undervalued stocks Forbes Market Lessons: Understanding dividend potential — Hyun-Soo Lim Forbes Market Lessons with 26 high-yield stocks : 20 Highly Profitable Companies by Hyun-Soo Lim Forbes Market Lessons: Reserve Prices, 14 Cheap Stocks by Hyun-Soo Lim Forbes What is ROE? — About Winners and Losers Market Lessons by Hyun-Soo Lim by Forbes Market Lessons: Shareholders Yield — Venture Beyond Dividends with These 16 Stocks By Segun Olakoyenikan By Forbes Market Lessons: Defining Corporate Multiples — By Segun Olakoyenikan Forbes Market Lessons: What Free Cash Flow Says Are You Undervalued — 16 In Stocks by Segun Olakoyenikan Forbes Market Lessons: Measuring Debt — 16 Cash-Rich Companies by Segun Olakoyenikan Forbes Market Lessons: Comparing Price and Sales as Value Flags — Forbes Market Lessons by William Baldwin : How to Find Fast and Steady Earnings Growth by William Baldwin Forbes Market Less Sons: 20 Companies with Remarkable Earnings per Share Growth by William Baldwin
Source link
