While searching for a suitable investment option, value investors with varied risk appetite are unlikely to consider price/earnings to growth (PEG) ratio among a number of other popular metrics like price/earnings (P/E), price/sales (P/S) or price/book value (P/B).
This is because they often find this ratio complicated, considering the limitations in calculating the future earnings growth potential of a stock.
However, at a time when volatility strikes every second day, it is pointless to ponder on methods, which do not consider a stock’s future growth rate while calculating its intrinsic merit. Yardsticks such as dividend yield, P/E or P/B are most commonly used to single out whether a stock is trading at a discount.
However, these ratios, while not taking into account the future growth potential of a stock, may end up convincing us to invest in stocks that are at a discount just because of their poor show. This may often lead to “value traps” — a situation when these value picks start to underperform over the long run as the temporary problems, which once pulled down the share price turn out to be persistent.
In such a case, even if you buy a stock at less than its fair value, you might still end up paying more. And here comes the importance of this not-so-popular but crucial value investing metric, the PEG ratio.
The PEG ratio is defined as: (Price/ Earnings)/Earnings Growth Rate
A low PEG ratio is always better for value investors.
While P/E alone fails to identify a true value stock, PEG helps to find the intrinsic value of a stock.
There are some drawbacks to using the PEG ratio though. It doesn’t consider the very common situation of changing growth rates such as the forecast of the first three years at a very high growth rate, followed by a sustainable but lower growth rate in the long term.
Hence, PEG-based investing can turn out to be even more rewarding if some other relevant parameters are also taken into consideration.
Here are some of the screening criteria for a winning strategy:
PEG Ratio less than X Industry Median
P/E Ratio (using F1) less than X Industry Median (for more accurate valuation purpose)
Zacks Rank of 1 (Strong Buy) or 2 (Buy) (Whether good market conditions or bad, stocks with a Zacks Rank #1 or 2 have a proven history of success.)
Market Capitalization greater than $1 Billion (This helps us to focus on companies that have strong liquidity.)
Average 20 Day Volume greater than 50,000 (A substantial trading volume ensures that the stock is easily tradable.)
Percentage Change F1 Earnings Estimate Revisions (4 Weeks) greater than 5% (Upward estimate revisions add to the optimism, suggesting further bullishness.)
Value Score of less than or equal to B: Our research shows that stocks with a Style Score of A or B when combined with a Zacks Rank #1, 2 or 3 (Hold) offer the best upside potential.
Here are five of the 28 stocks that qualified the screening:
The Kroger Co. KR: Headquartered in Cincinnati, OH, Kroger is one of the nation’s largest grocery retailers operating 2,800 retail food stores in 35 states and the District of Columbia under banners including Kroger, City Market, Dillons, Food 4 Less, Fred Meyer, Fry's, Harris Teeter, Jay C, King Soopers, Mariano's, Pick 'n Save, QFC, Ralphs and Smith's. The company has an impressive expected five-year growth rate of 10.4%. The stock currently has a Value Score of A and a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.
Colfax Corporation CFX: Headquartered in Fulton, MD, the company is one of the leading manufacturing and engineering companies, specializing in products and services related to air and gas handling, and fabrication technology. The stock currently sports a Zacks Rank #1 and has a Value Score of B. The company also has an impressive growth rate of 28.2% for the current year.
Boise Cascade Company BCC is one of the largest producers of engineered wood products and plywood in North America and a U.S. wholesale distributor of building products. Apart from a discounted PEG and P/E, the stock holds a Zacks Rank #2 and has a Value Score of A.
KB Financial Group Inc. KB is a global engineering, construction and services firm, supporting market segments of global hydrocarbons and international government services. The company has a diverse portfolio of services like proprietary technology and consultation; engineering, construction, procurement and asset maintenance. The company currently holds a Zacks Rank #1 and has a Value Score of A. The company also has an impressive expected five-year growth rate of 9%.
Avnet, Inc. AVT is one of the world’s largest distributors of electronic components and computer products. The company’s customer base includes original equipment manufacturers (OEMs), electronic manufacturing services (EMS) providers, original design manufacturers (ODMs), and value-added resellers (VARs). The company holds a Zacks Rank #2 and has a Value Score B. The stock also has an impressive earnings growth rate of 17.6% for the current fiscal.
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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.
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