Value investing is my favorite market strategy. Who wouldn't want to seek out undervalued companies, aiming to buy a dollar for $0.50? (Or at least, no more than $0.80?) Still, if you're a value investor, you surely have pangs of envy on occasion, watching certain stocks earn amazing one-day gains. Luckily for you, being a value investor doesn't mean you have to lock yourself out of exciting, fast-growing stocks.
True, mutual funds often separate themselves into the value and growth camps. The division can help investors zero in on funds that focus on value above all, versus those that aggressively seek growth, but it doesn't mean that the two factors are mutually exclusive.
Coexistence is possible
Indeed, you can be both a value and growth investor. It simply involves seeking out rapidly growing companies, but aiming to buy them at discounts to their intrinsic values. And what sensible investor wouldn't want her or his investments to be both undervalued and growing at a respectable clip?
That said, finding such companies isn't always easy. One imperfect but useful metric to consider is the PEG ratio, which I first learned about many years ago from Fool co-founders David and Tom Gardner. (Not coincidentally, their Motley Fool Stock Advisor newsletter often looks for growth and value in the same companies.) The PEG ratio is a company's P/E ratio (ideally its forward one, based on the coming year's earnings), divided by its earnings growth rate (ideally, expected earnings growth over the coming five years).
The PEG is most useful when looking at companies with significant growth rates, rather than big, established slow-growers. (Big companies that might look bad on a PEG basis can still be terrific, paying hefty dividends.) In general, a PEG of 1.0 suggests that a company is fairly valued, and a PEG between 1.0 and 2.0 is common for many companies. A PEG below 1.0 signals that you might be looking at a bargain.
Here are a few companies that popped up in a recent screen at Yahoo! Finance for low-PEG stocks with substantial projected earnings growth rates over the next five years:
Company | PEG | Growth rate |
|---|---|---|
America Movil (NYSE: AMX) | 0.49 | 32% |
Diamond Offshore (NYSE: DO) | 0.29 | 35% |
Tyco International (NYSE: TYC) | 0.73 | 21% |
Cummins (NYSE: CMI) | 0.55 | 21% |
NII Holdings (Nasdaq: NIHD) | 0.60 | 34% |
Flextronics (Nasdaq: FLEX) | 0.57 | 20% |
Sunoco (NYSE: SUN) | 0.47 | 17% |
In perspective
Should you immediately park these companies in your portfolio? Not necessarily. Remember that the PEG ratio is based largely on earnings per share (EPS) -- a number that can be fudged, if a company wants to fudge it. Continual share buybacks can certainly be good for shareholders, but they can also boost a company's EPS by shrinking the pool of shares among which earnings must be divided. Provided it buys back enough shares, a company can report rising EPS without ever increasing its net income. Companies can also sometimes strategically time when they recognize revenue. In addition, the "growth" component of the PEG is an estimate, and we know how accurate those can be.
The PEG ratio is a good initial screening metric that can guide you to some promising candidates. From there, you'll need to do further research, perhaps assessing financial health and debt levels, profit margins, revenue growth rates, or competitive advantages.
A shortcut
Even our investing newsletters use the PEG. For example, in Motley Fool Stock Advisor a while ago, David Gardner wrote about an Indian company specializing in information-technology outsourcing, noting that its expected growth rate is 25%, its forward P/E ratio is just 21, and its PEG is less than 0.9. He noted that it "looks cheaper than its rivals on just about every measure, particularly enterprise value over free cash flow."
So as you invest, consider looking for value and growth in the same stocks. That way, you can enjoy and profit from both in your portfolio.
