Years ago, investors, stock brokers and financial advisors wanted to know the “P/E” of the equity before making a buy-decision. A low P/E meant that the stock was cheap and market forces would lead to price appreciation. The opposite theory also was considered Wall Street Fact: A high P/E represents an over-valued stock and one that would devalue in the future. If you mentioned a stock, the next question was: “What’s its P/E?” Before we go further, let’s define:
P/E Ratio or Price-Earnings Ratio– A valuation ratio that compares the price of a stock to its per share earnings:
P/E Ratio = Price per Share/Earnings per Share (EPS)
If the previous 4 quarters of earnings are used, it is referred to as trailing P/E. If the expected next 4 quarters are used, it is called forward P/E.
The problem I noticed right from the getgo was that many of the companies with high P/Es back in the early 1990s, were the ones that performed the best. These were the growth companies. Institutional investors were willing to pay more for these companies, driving up prices, due to the expectations that earnings will be increasing. Peter Lynch, in his book, One Up On Wall Street, addressed this issue by stating that “The P/E ratio of any company that’s fairly priced will equal its growth rate“. He adds, ….”every stock price carries with it a built-in growth assumption”. So, if the P/E = Growth, the stock is fairly priced no matter what the P/E is. Enter the PEG ratio.
PEG = PE Ratio/Annual EPS Growth
Once again, the PE can be trailing or projected and the EPS Growth can be expected growth for the next one year or five years. Yahoo Finance uses a 5-year expected growth rate and an averaged PE when calculating PEG and later in this article I will give you information as to how to access this information. In general, a lower PEG is better and a PEG of ”1″ is considered to represent a fairly valued equity. This is not a scientific number because it is based on expectations. However, to neglect totally, the fact that there should be corporate earnings growth, is rendering the P/E ratio useless especially for growth companies. The IBD 50 has many growth companies rendering the PEG much more pertinent than the PE ratio.
Disadvantages of the PEG Ratio:
- Larger corporations offer higher dividends and less growth opportunities
- Does not relate corporate growth to overall growth of the economy
- Inflation is not factored in
- Growth projections may not be accurate
Despite these limitations, in the eyes of this investor, the PEG is of much greater application to us as we write calls predominantly on high growth companies. In addition, we can more accurately compare companies in different industries. If a stock has a high PE in a high growth industry, PEG will level the playing field with a low-PE stock in a slower growth group. Please note that if a company offers dividends, the PEG Ratio does NOT take this into account and therefore renders the PEG less applicable for these companies. So how do we account for companies that provide dividend income? Enter the PEGY Ratio:
PEGY = PE Ratio/ Expected Earnings Growth + Dividend Yield
Where to access this information:
Type in stock ticker and “get quote”
In left column, under “Company” click on “key statistics”
Below is an example of the page with these stats:
Circled in red is the PEG based on a 5-year expected growth rate and circled in green is the projected dividend yield for calculating PEGY ratio.
What Fundamentals does the BCI System Utilize?:
Plenty…although it doesn’t take us all that long to calculate. First, let’s look at the IBD 50 stocks and the fundamentals evaluated:
- Return on Equity
- Earnings per Share rating
- Annual EPS % change
- Last Quarter EPS % change
- Next Quarter EPS % change
- Last Quarter Sales % change
In addition, we run the stocks through the SmartSelect (Green Alert) ratings. The “EPS Rating” compares a company’s earnings per share growth on both a current and annual basis with other publicly traded companies. It compares the company’s most recent two quarters of EPS growth with its 3-5 year annual growth rate.
Furthermore, the Scouter Rating factors in many of the fundamental qualities of equities that have proven statistically to be predictive of stock performance in the past. In other words, we have all bases covered when it comes to fundamental ratios and analysis.
I will be presenting a FREE seminar on Tuesday July 12th @ 7PM for the Long Island Stock Traders Meetup Group. The topic is “Using Covered Call Writing to Increase Dividend Yield of High Dividend Yield Stocks”. You do not need to be a member of this club to attend. It will be held in a huge state-of-the-art auditorium at The Plainview-Old Bethpage Public Library:
999 Old Country Road
Plainview, NY 11803
Hope to see you there.
Once again we experienced a week of mixed economic reports:
- The Federal Reserve downgraded its 2011 GDP forecast to 2.8% from 3.2%
- The FOMC left its target fed funds rate at between 0% and 2.5% “for an extended period of time.”
- The 1st quarter GDP grew at an annual rate of 1.9% a slight upward revision
- The FOMC noted that “core” long-term inflation remains stable
- Sales of new homes dropped by 2.1% in May while the supply of unsold homes declined to 6.2 months, the lowest since mid-2010
- Sales of existing homes dipped 3.8% in May for the 2nd consecutive month
- New orders for durable goods advanced 1.9% in May after dropping 2.7% in April
For the week, the S&P 500 fell by 0.2% for a year-to-date return of 1.8% including dividends.
In November of last year I published an article discussing yield curves. Here is a paragraph from that article:
Steep Curve: Steep Yield Curve- 1992
This results when we have a greater-than-normal gap between the shorter and longer term treasuries as we see here in April of 1992. This marks the beginning of an economic expansion shortly after a recession. By 1993, the GDP was expanding by 3% per year and by the following year short-term interest rates had increased by 2 percentage points. That’s why investors were demanding greater long-term returns. Those investors who used this curve to increase their stock holdings were rewarded with a 20% return over the next two years (Russell 3000).
Next let’s take a look at the current yield curve:
Many economists consider the yield curve the most important leading economic indicator and it is telling us that a double-dip recession is not on the horizon. This will eventually lead to banks borrowing short term and lending long term once they have recovered from their excesses of 2008. Historically, the yield curve has been the first of the leading indicators to signal a change in the business cycle. The past 7 expansions lasted 71 months on average and the current one is not even two years in the making. It is impossible to predict markets with 100% certainty but to ignore history is a mistake Blue Collar Investors refuse to be guilty of.
IBD: market in correction
BCI: This site remains cautiously bullish on the economy but hedging by selling predominantly in-the-money strikes due to the short-term volatility.
The best in investing to all,
Alan ([email protected])