The PEG Ratio
Two High-Quality Companies
Back in 1946, Dr. Wilson Payne and Benjamin Graham held meetings at Babson College to find a way to calculate the true fundamental value of a company. Dr. Payne was the Dean of the Investment Department at Babson College (known back then as Babson Institute) and Benjamin Graham was professor of Advanced Security Analysis at Columbia University and investment advisor with the Graham-Newman Corporation. The two collaborated to devise formulas that would estimate a fair value range for stocks based on Mr. Graham's guidelines.
Many years later, I attended Babson, 15 miles west of Boston, and majored in Finance and Investments. I had the good fortune to take several courses taught by Dr. Payne, who made a lasting impression on me. Dr. Payne, a genius in math, made learning fundamental securities analysis trouble-free. His teachings were based upon Benjamin Graham's analyses.
After graduating from Babson, I worked for Paine, Webber in Boston for a few years and, after a stint in the Army, I was hired as Director of Research at Econometrics Research and Management in Boston. I was given the task of developing a computerized research system to analyze and evaluate stocks. I called upon my old college professor, who was more than willing to lend assistance for free!
In 1969, Dr. Wilson Payne and I teamed up to develop computerized models using the formulas which he and Ben Graham devised to estimate the true fundamental value for companies 23 years earlier. We hired Dr. Richard Fey, a math professor at Boston University, and two computer programmers. And there I was, a newbie in the very complex world of investments, standing among giants!
We developed a reliable system to estimate Maximum Buy Prices to indicate when to buy a stock, and Minimum Sell Prices to estimate when to sell a stock. In addition, we added Benjamin Graham's guidelines for standards of quality, value and earnings growth to quantify each company's attributes for comparison purposes.
I left Econometrics a few years later, but not without buying the exclusive rights to use the software programs that my team worked so hard to develop. I still own the rights and now use my computers to perform all of the calculations we developed decades ago. I am happy to report that the analyses we developed, based on Benjamin Graham's teachings during the 1930s and 1940s, still work very well!
How can you adapt what I have learned during the past several decades and create your own simplified investment approach? Very easy. I can get you on your way to steady, above-average profits using just two metrics: the Standard & Poor's Quality Ranking and the PEG Ratio.
First, 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 called 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 or occasionally a B ranking, if I believe the company has exceptional prospects. S&P rankings are usually provided on your broker's website. Just go to the stock research tab and enter S&P in the search box.
In addition to a high S&P Quality Ranking, I recommend using the PEG ratio to measure the degree to which a stock is undervalued. I use the ratio to find stocks selling at reasonable prices. The PEG ratio is calculated by dividing the price-to-earnings (P/E) ratio by the earnings growth rate. Comparing PEG ratios will provide a good measure of which stocks are undervalued and selling at bargain prices.
The price used in the P/E ratio is the stock's recent 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.
During the past seven years, I have recommended companies with high S&P Rankings and low PEG ratios every six months in the Cabot Benjamin Graham Value Letter. My recommendations have increased 48% compared to an advance of 14% for the Standard & Poor's 500 Index during the same seven-year period through January 24, 2012. High-quality stocks with low PEG ratios have consistently outperformed the stock market indexes in both advancing and declining markets. Investing in quality stocks at bargain prices makes sense in any stock market environment.
Two good examples of high-quality companies with low PEG ratios are FedEx (FDX) and Universal Health (UHS). The companies have S&P Quality Rankings of B or better and PEG ratios of less than 1.00, meeting my objectives.
Standard & Poor's Quality Ranking for FedEx is B+, which indicates the company has produced steady earnings and dividend performance during the past five to 10 years. My calculation of FedEx's PEG ratio of 0.85 is based upon the current stock price of 91.12, my forward 12-month earnings per share estimate of 6.54, and my estimated five-year earnings per share growth rate of 16.5%.
Standard & Poor's Quality Ranking for UHS is B+, which is a reflection of the company's strong balance sheet and steady earnings and dividend performance during the past 10 years. My calculation of UHS's PEG ratio of 0.76 is based upon the current stock price of 41.45, my forward 12-month earnings per share estimate of 4.33, and my estimated five-year earnings per share growth rate of 12.7%.
FedEx (FDX) (Current 1/25/12 Price is 91.12; Max Buy Price is 95.76) provides worldwide on-time air express delivery for packages and freight in 220 countries, and door-to-door delivery of small packages in North America. The company also operates 1,200 copy centers (formerly Kinkos), which offer various business services.
Growth in the package shipping business is accelerating due to a rise in online shopping. The surge in demand has allowed FedEx to boost freight rates by 6.7% in September 2011 and another 5.9% in January 2012. Most importantly, the U.S. Postal Service (USPS), FedEx's competitor, will cut costs and services beginning in 2012 to balance its budget. USPS estimates most deliveries will take two to three days within the U.S., rather than the current one to two day delivery. Customers will likely rely more heavily on FedEx and UPS to handle important deliveries.
FedEx will spend $2 billion on new aircraft to fly to additional destinations. The expanded international operations will drive revenues and earnings growth in 2012 and beyond. Revenues will likely increase by 19% and EPS by 14% during the next 12 months. The company pays a small dividend, and the PEG ratio of 0.85 is attractive. FDX is low risk and sports an S&P Ranking of B+.
Universal Health `B' (UHS) (Current 1/25/12 Price is 41.45; Max Buy Price is 44.07) owns and operates acute care and surgical hospitals, and behavioral health, ambulatory surgery and radiation oncology centers in 37 states.
The November 2010 acquisition of Psychiatric Solutions has provided a big boost to sales and earnings at Universal Health. In addition, the acquisition allows a better balance between acute care and behavioral health. Psychiatric Solutions has produced rapid growth, high occupancy rates, longer stays, and considerably lower uncompensated care.
Universal is expanding its outpatient services to help reduce healthcare costs for patients. The company is also implementing efficiency programs to improve financial performance while enhancing patient satisfaction and outcomes. We expect sales and earnings to increase 10% and 14% respectively during the next 12 months. UHS pays a small dividend, and the PEG ratio of 0.76 is very reasonable. UHS is low risk with an S&P ranking of B+.
Until next time - be kind and friendly to everyone you meet.
J. Royden Ward
Editor of Cabot Benjamin Graham Value Letter
Editor's Note: You can read more about PEG Ratio analysis and Benjamin Graham and get continuing coverage of FedEx and Universal Health in the Cabot Benjamin Graham Value Letter. There you'll not only find buy and sell advice for FedEx and Universal Health, you'll get 20 other excellent value stock recommendations from J. Royden Ward each and every month. Roy applies the strategy of the father of value investing, Benjamin Graham, to find the market's best undervalued stocks. And he will tell you exactly when to sell. Seven of Roy's recent recommendations have gained more than 25% in less than six months using the PEG ratio system. Remarkable! Don't miss out on his next recommendations.