PEG Ratio Calculations
Reliance Steel & Aluminum (RS)
A sure-fire method to find stocks that will outperform the stock market during the next year or two is to ferret out high-quality stocks with low PEG (Price Earnings Growth) ratios. Many of you know how to calculate PEG ratios, but you may not know that many professional analysts calculate the ratio differently depending on their objectives.
Here are three methods to calculate this important ratio.
First Method: Determine the PEG ratio by dividing the price to earnings (P/E) ratio by the earnings growth rate. The price in the P/E ratio is the stock’s recent stock price—I used the July 25, 2012 closing price in today’s calculations. 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. This method is best applied to growth stocks with high short-term and long-term growth expectations.
Second Method: Rather than using estimated EPS, the last actual 12-month EPS are used. The P/E ratio is therefore calculated by taking the current price and dividing by the last four quarters of EPS, also referred to as current EPS. The P/E is then divided by the forecast five-year EPS growth rate, the same growth rate as used in the first method. This PEG method is more conservative and is best applied to value stocks with low P/E ratios.
The Third Method brings the dividend yield into play. The P/E ratio is calculated as in the Second Method using last 12-month EPS. Then add the dividend yield (annual dividend per share divided by current price) to the five-year EPS growth rate. Divide the P/E ratio by the sum of the growth plus yield. This is a good method for comparing companies paying higher than average dividends.
Lastly, 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 reliable dividend income and price appreciation.
You can use 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.
For more than 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 more than doubled Standard & Poor’s 500 Index during the same seven-year period through July 25, 2012.
And 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 Aflac (AFL) and Reliance Steel & Aluminum (RS). The companies have S&P Quality Rankings of A- or better and their PEG ratios are less than 1.00, using the Third Method described above.
Standard & Poor’s Quality Ranking for Aflac is A-, which indicates the company has produced steady earnings and dividend performance during the past five to 10 years. My calculation of Aflac’s PEG ratio of 0.59 is based upon a stock price of 41.29, current earnings per share of 5.02, my estimated five-year earnings per share growth rate of 10.8%, and the current dividend yield of 3.2%.
Standard & Poor’s Quality Ranking for Reliance Steel is also A-. My calculation of RS’s PEG ratio of 0.72 is based upon a stock price of 44.98, current earnings per share of 5.02, my estimated five-year earnings per share growth rate of 10.3%, and the current dividend yield of 2.2%.
Aflac, Inc. (AFL) is the world’s largest supplemental cancer insurance provider, deriving 75% of its business from Japan. Most of Aflac's policies are individually underwritten and marketed at worksites through independent agents, with premiums paid by the employee.
Aflac Japan’s insurance products are designed to help pay for costs that are not reimbursed under Japan's national health insurance system, and include supplemental health and life insurance. Aflac Japan provides insurance to one out of every four Japanese households and the company’s policy-renewal rate is over 90%.
Aflac has expanded its product line and added new marketing venues in recent years. Non-cancer insurance policies now account for 70% of new sales. Rapid growth in Japan is propelled by success in selling through banks and post offices. Sales reps are located at many banks and post offices throughout Japan to sell Aflac products to customers.
U.S. sales are lagging, but the company’s focus on new products and its successful promotions in Japan are producing strong performance. Sales increased 13% and EPS jumped 40% to $5.02 during the four quarters ended June 30, 2012. The increases were propelled by better than expected sales from bank and post office locations, and by lower investment portfolio losses.
I forecast sales and earnings per share growth of 9% and 17%, respectively, during the next 12 months. Growth could receive an additional boost if lackluster U.S. sales improve noticeably and investment losses diminish to zero.
AFL shares sell at just 8.2 times current EPS. New products and further successes in Japan will produce strong growth in future years. AFL sells at a low price because investment losses have hurt earnings during the past four years. Most of the investment risk has been removed from Aflac’s investment portfolio now, however. With a low modified PEG ratio of 0.59 and a dividend yield of 3.2%, AFL shares are a bargain. The company has raised its dividend for 29 consecutive years. Buy Aflac now.
Reliance Steel & Aluminum (RS) is one of the largest metals distributors in the U.S. The company’s service centers provide specialized metals processing services and distribute more than 100,000 metal products, made primarily from steel and aluminum.
Reliance buys large quantities of raw metals from primary metals producers. The company then sells smaller quantities to clients after cutting and shaping the metals, and performing other services. Reliance sells to a diverse customer base in the machinery, aerospace, oil drilling, mining, farm equipment, and construction industries, and to customers in many other industries.
Reliance has achieved great success by acquiring smaller competitors at bargain prices during the past decade. Sales increased 20% and earnings climbed 35% during the past four quarters ended June 30, 2012. Results were aided by stable pricing and strong demand from customers in the oil and gas, aerospace, and farm and heavy equipment industries. Management expects demand to continue to be strong during the next several quarters.
I expect sales to rise 9% and EPS to advance another 15% during the next 12 months. Reliance’s strong balance sheet will enable the company to continue to acquire competitors. The company has acquired several companies thus far in 2012, which bodes well for future results.
RS shares sell at 9.0 times current EPS with a dividend yield of 2.2%. The quarterly dividend was increased from 0.15 to 0.25 on July 26. The company’s stock price tends to be volatile, as a result of erratic quarterly earnings, but I believe the current low price and low PEG ratio of 0.72 presents an excellent buying opportunity. Buy RS now.
Until next time, be kind and friendly to everyone you meet.
J. Royden Ward
Editor of Cabot Benjamin Graham Value Letter
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