The PEG Ratio
Two High-Quality Companies
How to Calculate PEG Ratios
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 to earnings growth) ratios. Many of you know how to calculate PEG ratios, but if you need to review the several ways to compute this important ratio, read my July 26, 2012 Cabot Wealth Advisory to refresh your memory.
The PEG Ratio
I determine PEG ratios using the following method because it brings the dividend into play. First, let’s look at the ingredients. The inputs are simple: the current stock price of a company (P), the latest four quarters of earnings per share (EPS), an estimate of how fast earnings per share will grow during the next five years (G), and finally the latest quarterly dividend.
The next step is to calculate the price to earnings ratio (P/E) by dividing the current stock price (P) by the latest four quarters of earnings per share (EPS). Then the latest quarterly dividend is multiplied by four to convert the quarterly amount to the annual dividend (D), and D is then added to the five-year EPS growth estimate (G). Finally, the P/E ratio is divided by the combined Growth and Dividend to determine the PEG ratio.
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Many investors do not include the dividend in the PEG ratio, but I believe my calculation is an excellent method to compare companies paying higher than average dividends. Maybe I should call it the PEGnD ratio--to be used only by intelligent investors!
If you are using Microsoft Excel spreadsheets or similar spreadsheets, this following formula will compute the PEGnD ratio: =SUM(P/E)/SUM(G+D)
In addition to low PEGnD ratios (below 1.00), 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 reliable dividend income and price appreciation.
How to find High-Quality Companies
A very simple measure can be used 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.
Since April 2005, 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 41% compared to an advance of 27% for the Standard & Poor’s 500 Index during the same period through February 11, 2013.
This Cabot Wealth Advisory is a follow-up to my Advisory featuring Low PEG ratios written on July 26, 2012. At that time I recommended buying Aflac (AFL) and Reliance Steel (RS) which had low PEGnD ratios. During the past six months, AFL and RS have increased 20% and 47% respectively while the Standard & Poor’s 500 Index has increased only 12%.
High-quality stocks with low PEGnD 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.
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Two good examples of high-quality companies with low PEGnD ratios are Microsoft (MSFT) and Prudential Financial (PRU). The companies have S&P Quality Rankings of B+ or better and their PEGnD ratios are less than 1.00. And the companies have another great attribute; they pay dividends yielding roughly 3%.
Microsoft (MSFT), the world's largest software company, develops, manufactures and licenses software products and services for different types of computing devices. Computer software includes the Windows operating system, the Office application suite and cloud computing services. The company also designs and sells hardware, including entertainment products, digital music devices and personal computer products.
Microsoft’s new Windows 8 operating system designed for computers, smartphones, and tablets is enjoying strong demand from users. In addition, Microsoft’s new tablet computer, called the Surface, has won high praise for its innovative features. The company controls the design, manufacture and marketing of Surface in an attempt to compete head-on with Apple, which controls the design, manufacture and marketing of its products.
Xbox consoles and Kinect movement games continue to gain market share. Microsoft’s Skype voice over Internet protocol service (VoIP), acquired in May 2011, is providing rapid growth.
I forecast 15% sales and EPS growth during the next 12 months ending 12/31/13. The company could beat my forecast if new products, such as the Surface, exceed expectations.
At 10.6 times latest EPS of 2.61, MSFT shares are way undervalued. Microsoft pays a generous dividend yielding 3.3%. I have calculated the PEG ratio at an attractive 0.75, based upon the 10.6 price to earnings ratio, expected 11.0% EPS growth, and 3.3% dividend yield: well below my maximum limit of 1.00. Buy MSFT now.
Prudential Financial (PRU), a financial services leader with approximately $1.06 trillion of assets under management as of December 31, 2012, has operations in the U.S., Asia, Europe and Latin America. Prudential offers investment management, group insurance and other financial services in the U.S., and life insurance overseas.
Sales moved up sharply in 2012 as a result of acquisitions and two new major contracts for pension services. Acquisition costs, sluggish growth in the insurance business, and higher claims in the disability business caused earnings per share to slip 5%.
Prudential has a lot going for it in 2013. The acquisitions and new contracts will add considerable sales and earnings. Higher assets under management and increased pricing in the annuities business will add profits. The investment management business in the U.S. and insurance sales overseas will also provide a boost in 2013.
My forecast includes an earnings per share increase of 23% to 7.55 in 2013. From 2002 through 2012, Prudential shares paid an annual dividend. Starting in 2013, the company will pay dividends quarterly in March, June, September and December. Prudential will likely hike the dividend from an annual rate of 1.60 in 2012 to 1.80 in 2013.
At 9.3 times latest earnings per share, and with a dividend yield of 2.8%, PRU shares are clearly undervalued. I have calculated the PEG ratio at an attractive 0.82, based upon the 9.3 price to earnings ratio, expected 8.5% EPS growth and 2.8% dividend yield--well below my maximum limit of 1.00. In addition, I believe the initial quarterly dividend will provide a yield of more than 3% in 2013. Buy PRU now.
Until next time – be kind and friendly to everyone you meet.
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 Microsoft and Prudential in the Cabot Benjamin Graham Value Letter. There you'll not only find buy and sell advice for Microsoft and Prudential, 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. Four of Roy's recent recommendations have gained more than 27% during the past six months using the PEGnD ratio system. Remarkable!
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