The PEG Ratio For Growth, The Super PEG And 20 Cheap Stocks

How much are you paying to get an upswing in earnings? PEG tries to measure that. Super PEG does it better.

_{By William Baldwin, Senior Contributor}

Growth is worth a premium on Wall Street, but not just any premium. You need a metric to assess whether a company’s market value is out of line with the earnings growth it can deliver. Growth at a reasonable price is your target.

Compare a PE (price/earnings) to a G (growth rate) and you get PEG, the classic formula for measuring the price tag on a growth stock. But PEG has deep flaws. There’s something better, which here will get the name Super PEG. Super does not mean that the new ratio is the be-all-end-all quantitative metric, only that it supersedes the defective old ratio.

We’ll use Super PEG to spotlight 20 out-of-favor stocks that will turn out to be bargains if they can maintain their recent growth rates for a while. Among them are some homebuilders, a company that sells socket sets and a truck dealer.

After that: a list of companies that look overpriced by the old PEG but show up as worth a look when you use Super PEG. Junk food, swimming pools and hardware are featured there.

The classic PEG is simple. Hershey’s price/earnings multiple is 20, its expected earnings growth rate 5 (in percentage points). Divide one number by the other and you get the PEG of 4 shown at Yahoo Finance. By that measure the shares of the confectioner are way overpriced. PEG aficionados want to see a ratio of 1 or lower, such as a company trading at 15 times earnings and expanding its earnings per share at a 15% clip.

Computational simplicity was a virtue when you did arithmetic with a slide rule. It isn’t now.

PEG has two flaws. One is that it assumes a linear relationship between a growth rate and what it delivers. But that’s not how compounding works. A decade of 30% growth does not result in earnings three times as high as a decade of 10% growth. It gives you five times as much.

The other thing PEG does wrong has to do with dividends. A company with flat earnings and a 7% yield delivers exactly as much to shareholders as a company with 7% earnings per share growth and no dividend. PEG ignores dividends. It thinks the latter company is doing all right but the dividend payer is worthless.

Super PEG takes an entirely different route to measuring the payoff from growth. It measures how much you pay now to get a certain level of earning power down the road, and then compares that to what you pay to get future earning power from the S&P 500 index. If you can buy future earnings from a stock at half the price you’d pay investing in the market average, the Super PEG is 0.5.

When is “down the road”? Any period can be inserted in the formula. Our first list, of cheap stocks, uses a very conservative five-year horizon. It also assumes that historically terrific growth regresses to the mean. More precisely: It starts with EPS growth over the past decade, lets the target company continue at that rate for one year, then has its future growth rate descend in equal steps over five years to the market average.

The historic growth rates displayed here reflect the steepness of exponential lines fitting their EPS records. That method is explained in Market Lessons: Finding Fast And Steady Earnings Growth. Dividends are added in to future growth rates in earning power, as if you were using them to buy more shares.

Here’s a list of stocks priced cheaply in relation to expected future earnings. It’s limited to companies in the top quartile of historic earnings predictability.

Are all these stocks going to outperform? Scarcely. The Super PEG, or any metric, won’t tell you how to get rich. It just tells you what stocks Wall Street disfavors. The price/earnings ratio, the most basic of metrics, is like that. A low P/E is low for a reason. You have to figure out what that reason is, and whether the reason justifies the market’s disaffection. So too with low Super PEGs.

Evidently investors are skeptical about homebuilding. Toll Brothers, D.R. Horton and Lennar are here. So is Owens Corning, which makes the pink insulation stacked high at Home Depot.

The internal combustion engine has an unfavorable reputation. That may explain the appearance of Penske Auto Group, which sells and services trucks; LKQ, which distributes aftermarket repair parts, and Snap-on, which sells socket wrenches to mechanics. It could be that we are about to enter a halcyon era of low-cost electric vehicles that never need repair and never get into crashes. But if you suspect that this future is a ways off, you’ll like traditional players in the auto sector.

The next list highlights stocks that are richly priced in Super PEG terms. They get the benefit of the doubt, with an assumption that above-market growth lasts for a decade.

Some of these fast growers will validate investors’ exuberance. But really. One hundred and thirty-five times earnings for a restaurant chain? What if people get tired of chicken wings?

Next are companies that are rated costly by the old PEG but put in a different light by Super PEG. It’s easy to see what’s going on with Enterprise Products Partners, which handles crude; Evergy, the midwestern utility, and General Mills, a leader in junk food: The traditional PEG doesn’t handle dividends correctly.

The futurist list features companies whose apparent worth is immensely improved by using a ten-year rather than a five-year phaseout of superior growth. They’re bargains if you think their growth trajectories have lasting power.

Finally, we have speculative plays that are cheap relative to an earnings history that is strong but uneven.