Investing--Fred Barbash, The Post: "How to PEG a Bargain"
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>>>How to PEG a Bargain
By Fred Barbash
Sunday , October 22, 2000 ; Page H01
I've been getting e-mail asking if it's time to go "bargain hunting," and if so, how to recognize a bargain.
I should heed the biblical proverb: "Even a fool, when he holdeth his peace, is counted wise: and he that shutteth his lips is esteemed a man of understanding."
But that would be a dereliction of duty. So I now openeth my mouth.
Just as investors overreact when the market is rocketing upward, so they overreact when it's in free fall. Going up, stocks are overbought. Going down, they often are oversold.
Overselling can create opportunities, which good fund managers take advantage of.
But many individual investors, from what I can tell, become paralyzed with fear.
For those with no money available for stocks, it's immaterial. For investors who want to increase their equity holdings, and who are financially secure enough to do so, the paralysis can be self-defeating.
Waiting around until various indexes "bottom out" sounds as if it makes sense. But even the best-trained minds have trouble bottom-spotting.
These days, looking for the bottom is more complicated than ever because this is a market not in free fall, but in sky dive. It has leapt from great altitude, been carried upward by gusts of wind, then downward and upward again, all while waiting for the parachute to open.
Conversely, waiting around until the markets "recover" makes no sense at all. What you're doing is waiting to buy until buying will cost you more.
So this probably is a time to be looking for bargains. But I'm not confident there are very many there.
What is a bargain? That's extremely subjective. A wildly overpriced stock that has become less wildly overpriced is not a bargain.
Nor is it necessarily a bargain when a stock over which you salivated suddenly declines and comes into reach. Its price may have tanked for a good reason.
What many fund managers search out are companies with unchanged expectations for earnings that, because of mob overreaction, have moved from overpriced to fairly priced and even underpriced.
Something called the "PEG ratio" attempts to measure just that phenomenon.
Now, bear with me for a moment.
The PEG ratio is calculated by dividing the price-to-earnings ratio of a stock by a company's projected earnings growth rate.
For example, if the P/E ratio is 10 and the projected growth rate for, say, five years is an annualized 10 percent, the PEG ratio is 1. That's considered a fair price.
If the PEG ratio is 0.5 (a P/E ratio of 10 and a growth projection of 20 percent), that's a hypothetical steal.
The idea is that a fairly priced stock has a P/E ratio that is equal to its projected earnings growth rate.
The concept of the PEG ratio was popularized by Fidelity's Peter Lynch and more recently by the Motley Fool Web site, where they call it the "Fool Ratio."
What, you may ask, is wrong with the using the price-to-earnings ratio?
Nothing. It's the same idea, except it provides a longer-term perspective. The "trailing" price-to-earnings ratio, the current price divided by the past year's earnings, tells you that a stock is trading at, say, 20 times earnings or 30 times earnings or, in the case of some highfliers, 300 times earnings. Using the so-called "forward P/E ratio" takes you a bit further--it tells you the price as a multiple of estimated earnings for the current fiscal year.
The PEG ratio goes out two years or three years or five years, based on the mean consensus of earnings estimates of professional analysts.
That is both its strength and its weakness--since the future becomes more uncertain as we move away from the present. Don't take it too seriously as any sort of prediction.
For comparative purposes, it's nonetheless valuable. When a stock's price declines because of market-wide or industry-specific panic selling but its earnings prospects remain the same or change little, you can watch the PEG ratio improve.
Morningstar Inc.'s Web site (http://www.morningstar.com) is among the best for monitoring PEG ratios. It allows you to screen for stocks with certain PEG ratios, which I did last week, in search of mid-cap and large-cap companies at 1 or below. In spite of what's happened in the markets this year, I didn't find that many.
Among them, possibly for the first time in years, was Dell Computer, which was at 1 exactly, with a forward P/E ratio of 28.5 and an estimated growth rate of roughly 28.5 percent annualized. Back in July, Dell's PEG was above 2.
By contrast, consider the PEGs of some of the hyper-growth stocks of the fiber-optics industry. The PEG of JDS Uniphase Corp. (JDSU) was 2.67 Thursday afternoon, rather high. Ciena (CIEN): 11.64.
I ran a screen at Morningstar for companies with market caps of at least a billion dollars and PEGs of 0.5 or less, considered the real value zone, and came up with 10 companies. Among them were Advanced Micro Devices (AMD); WorldCom (WCOM); AXA, the France-based insurance company; Fairchild Semiconductor (FCS); and Lam Research (LRCX.)
A PEG ratio of a stock needs to be compared with the PEG ratio of other stocks and of the industry. With each stock, Morningstar provides an industry comparison. For example, the average PEG for the computer industry is 1.9, which is also the average for the S&P 500.
PEGs come in different forms, using different numbers at different places. So if you want to do comparisons between stocks, be sure you're using comparable numbers. This is best achieved by using a single Web site.
The Motley Fool lets you do the calculating with its "PEGulator," and, with a lot of clicking, guides you to the numbers necessary to fill in the PEGulator blanks (go to fool.com.
You can go one step further using the calculator at StockSelector.com (go to old.stockselector.com/pegvalue). If you plug in the stock symbol, it figures what the stock price ought to be to produce a PEG of 1, and tells you how far away that price is from a stock's current price.
That calculator told me, for example, that EMC was priced roughly 70 percent higher than "fair"; Intel, at $42, about 13 percent higher; Motorola, 5 percent higher; Cisco, 52 percent higher.
Some examples of stocks significantly below the magic 1, according to this calculator, were Boston Scientific (BSX, 77.9 percent below "fair"), RF Micro Devices (RFMD, 34 percent), General Motors (GM, 26 percent), Tellabs (TLAB, 36 percent), Alcoa (AA, 43 percent) and Caterpillar (CAT, 17 percent.)
Now it's caveat time.
I mention these companies only as examples, not as recommendations to buy or sell.
PEG ratios are no better than the numbers that form them, which include estimates of earnings growth, which can turn out to be much too high or much too low. The further out the estimate, the less predictable the growth rate.
PEGs are less useful in industries such as banking and real estate. They are utterly useless for companies with no earnings.
The PEG ratio, like the P/E ratio, is merely a help, not an answer. It's for those moments when you're thinking, "Wow. This stock hasn't been down this low in two years. What a bargain!"
Nor does being priced at a bargain mean it's necessarily a value.
Companies have problems that are not necessarily quantifiable--litigation problems, management problems, execution problems--that can account for price decline but leave earnings projections unaffected.
Finally, no number, nor any collection of numbers, nor whole books of numbers, nothing, can predict future performance.
Fred Barbash can be contacted at barbashf@washpost.com. Of the stocks mentioned above, he owns Cisco Systems.
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