The most explosive combination in investing

What if you could invest in a company that had growth and was also undervalued?

By Zacks.com Jul 19, 2013 6:34PM

Image: Stock market report (© Photodisc Blue/Getty Images)By Tracey Ryniec

 

Come rain or shine, I'm a value investor. I love the thrill of buying a stock that the rest of the market is ignoring. Every once in a while, though, I sneak a peek at companies with double digit earnings growth, hear the siren call of growth and try to justify the valuation in order to buy the stock.


But what if you could invest in a company that had growth and was also undervalued?


I know what you're thinking; it's nearly impossible to find those stocks. It's the most explosive combination in investing: a value stock that also has growth.


But here's a little secret; those stocks do exist.


How do you find them?

 

The secret to finding both value and growth

Value investors have long looked to the price-to-earnings ratio (or P/E) as a screen for value stocks. A low P/E ratio is believed to mean that a company is undervalued.


However, Benjamin Graham, considered to be the "father" of value investing, found that a low price-to-earnings ratio wasn't enough to unearth the true undervalued companies. He looked to the PEG ratio instead, which combined both value and growth, a more potent combination.


The PEG ratio is calculated by taking the price-to-earnings (P/E) ratio and dividing it by the 5-year projected growth rate.


Confused yet?


These days you don't really need to figure it out yourself as most financial web sites, including Zacks.com, provide the PEG ratio for you as screening criteria when looking for stocks.


What's a good PEG ratio?

A company that is considered fairly valued will have a P/E ratio that equals its growth rate. So the PEG will equal 1.0.


A more expensive stock will be above 1.0.


Normally, a stock with a PEG ratio under 1.0 is considered "undervalued," as that means the market is underestimating the earnings and/or it is also growing faster than expected.


So that's what you should be looking for when you see the PEG ratio. You want a ratio under 1.0.

 

How the PEG ratio really works

1) You could have a company with a P/E ratio of 30 and a projected growth rate of 15%. This company clearly doesn't look like it's undervalued with a P/E ratio that high. You would be right. Plugging it into the formula, you get 30/15 = PEG of 2.0. Since 2.0 is above 1.0, it is considered an expensive stock.


2) Let's say you have a company with a P/E ratio of 40 and a projected growth rate of 50%. With a P/E of 40, it clearly would not seem to be a good value, but plugging it into the formula gives you a PEG ratio of 0.8 (40/50= 0.8). Since that is under 1.0, it is considered undervalued. The incredible growth rate counters the high P/E ratio.


3) In our third example, a company with a P/E ratio of 10, which is well within the value parameters for most investors and is usually considered pretty cheap, has a growth rate of just 7%. Putting it into the formula, you get a PEG ratio of 1.43 (10/7= 1.43), which is much too high to be considered undervalued despite the company's rather low P/E.

 

Have your cake and eat it too

The great thing about the PEG ratio is that it gives you two potent weapons: both value and growth. In investing, this combination is explosive. And it's easy to deploy in your investing strategy as it's already calculated for you on most investing web sites.


If you can combine these two factors, your odds of investing in companies with great prospects increases. But like using the P/E ratio to find value stocks, it shouldn't be the sole factor you look at when deciding what companies to invest in.


If you deploy the PEG ratio along with other criteria, like the Zacks Rank, the PEG ratio becomes a great screening tool.


Value investors really CAN get value and growth in the same stock.


Where to find value stocks that grow

I manage a Zacks portfolio that searches not for cheap stocks but for outstanding companies that are currently trading at least 25% to 50% below where they should be. Our mission is to signal "Buy" at just the right time --  as the market begins to catch on and the stock price begins to rise.


The Value Investor includes 22 stocks that are "on sale" right now, and are likely to head a lot higher in the months and years to come.


Tracey Ryniec is Zacks' Value Stock Strategist and serves as Editor in Charge of the Value Investor.

 

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14Comments
Jul 20, 2013 6:57AM
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Once again MSN Money... you are providing selected facts about an extremely volatile and risky venture that tends to attract lesser intelligent people. Our organized financial sector is broken. There can be no denial that Ben Bernanke- Federal Reserve Chairman has been authorizing the printing of $85 billion unsubstantiated dollars per month since 2009. Those monies go directly into his member banks and have supported "business platforms" not business enterprises that operate with a group of paper and button pushers and some clerical staff, not operations with significant personnel. They don't make or do things that benefit America or improve or economy. They HURT America by blockading jobs, colluding and using Twitter, Facebook and Linked-In to our disadvantage. The faster America liquidates ALL positions in EVERY business platform, the faster they will crumble and our BEST can pick up the pieces, build REAL enterprise from them and get the whole of the nation going, not dig a hole using Wall Street and burying the greatest nation on Earth- alive.
Jul 21, 2013 10:33AM
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This is merely an ad for Zachs. One does not have to pay for readily available PEG ratios and the like. Instead of having to be spoon fed everything, look around.
Jul 21, 2013 11:24AM
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Oh really Zack!  Just divide by the PEG?  Now who in the world is smart enough to predict that number?  Answer.....no one.  If anyone could accurately and consistently that value you wouldn't need anything else.  Doesn't anyone else see this fatal flaw?

Paul from Arizona
Jul 21, 2013 7:25AM
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Sheer genius! How come nobody thought of this before?

 

ROTFLMFAO

Jul 21, 2013 2:48PM
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Duh. Divide by the "5 year projected growth rate". Anybody know what that is? Most analysts can't agree on what's going to happen next week, let alone over 5 years; too many variables.

 

So here's the most explosive combination in investing: Pick stocks that go up in price, then sell them when they hit their high. Again, duh.

 

Or hire monkeys to throw darts at stock listings. I hear that works better than analysts anyway.

Jul 21, 2013 2:59AM
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IF MSN MONEY says buy GOLD, do not. 
IF MSN MONEY says short the market, go long. 
IF MSN MONEY recommends a certain sector like oil field services, oil or gas just avoid them. 

The stock market is easy. You invest in what you know or what you know to work. Find a global player or someone with potential to go global like Disney, McDonalds, etc.. because all new money craves one thing: the American way of life. Losers like MSN Money analysts who constantly try to short the American way of life always lose. NEVER bet against America. America means one thing overseas: innovation. We create new, we innovate the old, we progress. That is the American way. Send the failed GOP Congress packing and you will see American productivity explode upwards. 
Jul 21, 2013 4:43PM
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There is not a magic bullet out there for socks, but you have to use your Batman utility belt to trade on a regular basis.  This is great for people who are interested in the market, but have to figure it out for themselves.  Good for the education of regular people.

 

Look at AEG or STO.  Two very different companies with PEG ratios below 1, but which will be rising sooner?  To know that you may have to read an SEC report or two to find out.  Best of luck to us all.

Jul 21, 2013 12:45PM
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I love the cell phone in the photo. 1997 here I come!
Jul 21, 2013 4:40PM
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All you need to do is predict the future.  Dante puts the people who say they can do that in hell, with their heads put on backwards.
Jul 21, 2013 2:48PM
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P/Es, PEGs, ROI. ROR, YOY, QOQ, QOYQ, Div. increases, Sweet Geezus.

 

"5 year projections on Growth"...Sounds good to me, if they are correct...hmmm.??

What about competition, downturns, recessions etc.

 

Put it all together.....Go for it....Or get Financial overload.

Jul 21, 2013 7:39AM
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Like anyone has extra money to invest anyway. It doesnt matter if this is good information or not. Its a moot point.

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