Utilizing the PEG Ratio for Identifying Undervalued Growth Stocks
The Price / Earnings to Growth ratio, known as the PEG ratio, serves as a valuable tool for investors and analysts to gain a comprehensive understanding of a company’s performance and assess investment risk.
In the current market landscape marked by external disruptions, the concept of value investing is rapidly gaining traction. An example of the long-term successful use of the PEG ratio is Warren Buffett and his Berkshire Hathaway Fund which have used the PEG ratio in their stock analysis for decades that has provided their investors an annual 20% growth rate year over year.
Some current stocks that have experienced substantial growth in recent times highlight the remarkable effectiveness of this PEG Ratio investment strategy. In this context, we will delve into five such stocks: Alibaba Group BABA, Encompass Health EHC, Molson Coors Beverage TAP, Ford Motor F, and Albemarle Corporation ALB.
Further Insights into Value Growth Stock Investing
When seeking suitable investment opportunities, value investors with varying risk preferences often overlook the Price / Earnings to Growth PEG ratio amidst other widely-used metrics such as Price / Earnings P/E, Price / Sales P/S, and Price / Book Value P/B. This avoidance is typically due to the perceived complexity of the PEG ratio, stemming from challenges in predicting a stock’s future earnings growth potential. Instead, metrics like dividend yield, P/E, or P/B are commonly employed to identify stocks trading at discounted values.
However, solely relying on these ratios without factoring in a stock’s growth potential can lead to investments in undervalued stocks that underperform over the long term. This scenario, known as falling into a “value trap,” occurs when stocks initially identified as value picks struggle consistently due to persistent issues that previously caused their share prices to drop.
In such instances, even if an undervalued stock is purchased below its fair value, it can still result in overvaluation. This underscores the significance of the lesser-known yet crucial value investing metric: the PEG ratio.
The PEG Ratio is Defined as the Price Earnings Divided by the Earnings Growth Rate
For value investors, a lower PEG ratio is generally more favorable.
While the P/E ratio alone may fail to identify genuine value stocks, the PEG ratio aids in determining a stock’s intrinsic value.
Nonetheless, employing the PEG ratio has its limitations. It does not account for situations where growth rates change significantly, such as projecting a few years of high growth followed by sustained but slower growth in the long term.
Consequently, the effectiveness of PEG-based investing can be enhanced by considering other pertinent parameters.
Screening Criteria for a Successful Value Growth Stock Strategy
PEG Ratio Lower than the Industry Median (X)
P/E Ratio Lower than the Industry Median (X)
Market Capitalization Exceeding $1 Billion
Average Daily Volume Surpassing 500,000 shares
Increasing Forward Earnings Estimates from the Analysts
Prominent Growth Stocks Currently Meeting These Screening Criteria
Alibaba BABA
A leading e-commerce giant in China, Alibaba has transformed into a conglomerate with diverse businesses including logistics, food delivery, and cloud computing. Its three primary businesses are Alibaba.com, Taobao, and Tmall. Alibaba boasts an impressive five-year expected growth rate of 19.9%.
Encompass Health EHC
This company provides integrated healthcare services through a network of rehabilitation hospitals across 36 states and Puerto Rico. It offers high-quality, cost-effective care and possesses a discounted PEG and P/E, along with an anticipated long-term growth rate of 11.8%.
Molson Coors TAP
As a global beer and beverage products manufacturer, Molson Coors boasts a portfolio of renowned brands. These include global priority and regional champion brands. With a projected long-term growth rate of 7.3%, the company is a significant player in the industry.
Ford Motor F
A prominent automaker headquartered in Dearborn, MI, Ford produces, markets, and services a range of vehicles. Its operating segments include Ford Blue, Ford Model E, Ford Pro, Ford Next, and Ford Credit. In addition to a discounted PEG and P/E, Ford Motor anticipates a long-term growth rate of 7%.
Albemarle ALB
Based in Charlotte, NC, Albemarle is a premier specialty chemicals company with a strong presence in diverse global end markets. Its specialization spans various sectors including petroleum refining, consumer electronics, energy storage, and more. Albemarle holds a promising long-term expected growth rate of 12.6%.
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