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.

Featured Stock Picks

Each write-up features commentary on the picks from one or more of our expert stock market analysts, as well as company details and a stock chart.

More about Value Stocks

Buy low, sell high: it's the oldest trick in the book for a reason. Value stocks can be the safest way to big profits, but how do you find them?


Stock Picks

Norwegian Cruise Lines

Norwegian Cruise Lines (NCLH) is one of the “big 3” in the cruise industry. There’s a real growth story here thanks to a steady expansion in the firm’s ship count, along with an acquisition last year that gives it exposure to the high end of the market.

Constellation Brands

This maker of wines (Mondavi, Clos du Bois, Ravenswood), beer (Corona, Modelo and TsingTao) and spirits (Svedka, Black Velvet and Paul Masson) gets 89% of its revenues from the U.S. and 11% from Canada, so the strong dollar isn’t hurting.

Cheetah Mobile

My stock pick this week is a Chinese stock that was featured in the Other Stocks of Interest section of Cabot Growth Investor. (It’s also in the portfolio of Cabot China & Emerging Markets Report).

Cabot Wealth Advisory

Three Simple Options Strategies to Hedge Your Portfolio

By Paul Goodwin on July 02, 2015

Markets are used to all kinds of stressful events, and for the past year or so have taken the Greek debt crisis pretty much in stride. Up through last week, what we saw in the market was an unemotional averaging out of all investors’ estimates of the probability of a Greek default and the likely fallout (including Greece’s exit from the Eurozone).Read More >

Three Simple Options Strategies to Hedge Your Portfolio

By Jacob Mintz on July 01, 2015

On Monday, Paul Goodwin discussed the panic that sparked a greater than 2% decline in the markets on Monday. So how do you protect your portfolio from a pit bull and a swarm of bees?Read More >

Investors and the Genuinely Horrible Day

By Paul Goodwin on June 30, 2015

There’s nothing like a genuinely horrible day to get the attention of equity investors. Financial websites and online brokerage accounts must have registered a spike in visitors this morning as the investors who suffered through Monday’s storm tried to figure out which way the market’s winds might blow on Tuesday.Read More >