Two Systems to Evaluate a Stock's Value

By J. Royden Ward, Chief Analyst, Cabot Benjamin Graham Value Investor
From Cabot Wealth Advisory 2/15/10 Sign up for free Cabot Wealth Advisory e-newsletter

Here's my definition of fundamental analysis as a value investor: Fundamental analysis is any method to evaluate the prospects of a company and/or its stock by analyzing the qualitative and quantitative factors of the company.

There are hundreds of ways to determine whether a stock is undervalued or not. Some methods always work well, while other methods work for only a short time. Some methods are complicated, but others are simple.

I have been using a couple of simple value investing systems during the past 25 years that really work well. The first system is designed to find undervalued growth stocks, and the second system is designed to find bargain-priced value stocks. I call the first system the PEG (price/earnings to growth) ratio and the second the Benjamin Graham system.

The PEG Ratio

Twenty-five years ago, Standard & Poor's created the PEG ratio to measure the degree to which a growth stock is undervalued. I use the ratio to find high-quality growth stocks selling at reasonable prices. The PEG ratio is calculated by dividing the price to earnings (P/E) ratio by the earnings growth rate. The price used in the P/E ratio is the stock's most recent closing price.

Earnings consist of estimated earnings per share (EPS) for the next 12 months. The growth rate (the "G" in the PEG ratio) is the estimated rate of EPS growth for the next five years. A PEG ratio of less than 1.00 indicates that a stock is undervalued. The lowest PEG ratios are best.

In addition to a low PEG ratio, I look for good quality companies with a history of steady earnings and dividends growth. Quality companies may not be extreme bargains, but high-quality companies will likely produce dividend income and price appreciation upon which you can rely.

There is a very simple measure to determine which companies are high-quality and have produced steady earnings and dividend performance during the past five to 10 years. Standard & Poor's evaluates most stocks and assigns a ranking that they call the S&P Quality Ranking.

Companies with A+, A and A- S&P Rankings indicate high quality. I generally like to find companies with these rankings, although I will often include a company with a B+ ranking, if I believe the company has good prospects and a solid balance sheet with little debt.

High-quality stocks with low PEG ratios have consistently outperformed the stock market indexes in advancing and declining markets. Investing in growth stocks at bargain prices makes sense in any stock market environment.

The Benjamin Graham System

I have used one of Benjamin Graham's value investing methods for the past seven years in the Cabot Benjamin Graham Value Investor with great success. The method is based upon minimum price-to-earnings ratios, price-to-book value ratios and measures of quality. The full description of this analysis can be found in Benjamin Graham's book, "The Intelligent Investor."

Mr. Graham suggested that value investors should buy stocks that fit all of the following criteria:
(1)  The current price-to-earnings (P/E) ratio is 9.0 or less.
(2)  The price-to-book value (P/BV) ratio is 1.20 or less.
(3)  The long-term debt-to-current assets ratio is 1.10 or less.
(4)  The current assets-to-current liabilities ratio is 1.50 or more.
(5)  Earnings per share growth during the past five years is 1% or more.
(6)  The company currently pays a dividend.
(7)  The Standard & Poor's Quality Rank is B+ or better.

The list of seven requirements is somewhat long, but several stock screening sites, as well as your favorite broker, can find stocks that meet most or all of them.

Using this analysis, my recommendations have easily beaten the stock market indexes during the past seven years.

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