PEG Profits and Relative Values

04/08/2016 10:00 am EST

Focus: STOCKS

Charles Carlson

Editor, DRIP Investor

Dividend expert Chuck Carlson, explains the difference between price to earnings (PE) and price to earnings growth (PEG). The editor of DRIP Investor also highlights some stocks that stand out as PEG values.

Steve Halpern:  Joining us today is dividend expert, Chuck Carlson, editor of the industry-leading DRIP Investor. How are you doing today, Chuck?

Chuck Carlson:  I’m fine, Steven.  Thank you.

Steve Halpern:  Now, you wrote a terrific article for your subscribers recently helping to explain how to use PEG ratios in determining value, but before we turn to this ratio, could you first give an overview of the more common PE ratio and explain some of its shortcomings.

Chuck Carlson:  Sure, a valuation metric that’s often used by investors, and it has merit, there’s certainly nothing wrong with it, is what’s called the price earnings ratio or the PE ratio.

You compute a PE ratio on a stock by the taking the stocks per share stock price divided its annualized earnings per share, and you can a lot of times people will take the earnings estimate for the next 12 months or the next year.  

For example, let’s say you have stock that has a per share stock price of $20 and its 2016 earnings estimate is for $2 per share, that PE ratio would be 10.  

It would be 20 divided 2 so it gives you a bit of a benchmark to see how popular a company is, how much Wall Street is valuing the company’s earnings, and typically high PE stocks are more highly valued than low PE stocks which then Ergo makes low PE stocks potentially better values.  

A problem with PEs though is that, well one of the problems is trying to compare stocks from industry to industry is difficult.

There are certain industries such as utilities where PE ratios historically are on the lower end because of the industry’s growth prospects versus something like biotech or some of the internet areas where PE ratios are typically much higher because of the company’s expected growth rates.

So simply looking at a PE ratio of one stock versus another in totally different industries may not provide a lot of value in terms of really trying to assess where the value is in either of those two stocks.

Steve Halpern:  And one strategy that you use to try help while work through that problem is to use the price to earnings growth or PEG ratio.  Could you explain how this differs from the standard PE ratio?

Chuck Carlson:   What the PEG ratio takes into account is the future earnings growth of a company so if you see a stock that seems to have a high valuation based on its PE ratio knowing what the future growth rate is or expected future growth rate may not make that stock look to be so expensive after all.

And again, you determine the PEG ratio by taking the PE ratio of a stock and then dividing by the expected growth rate and our firm typically uses a five-year expected earnings growth rate in the denominator of the PEG ration.  

Again, what this shows you is how much is Wall Street really valuing the future growth potential, expected growth potential of a company, and it’s a nice way to view companies in different industry groups.  It’s kind of like an equalizer so to speak to see how Wall Street is valuing the future growth of a company.

Steve Halpern:  Okay, to help clarify the difference between these metrics, in your recent report to your subscribers, you compared Facebook (FB) relative to Coca-Cola (KO).  Would you share that analysis?

Chuck Carlson:  Sure.  At the time when I was doing the analysis, Facebook, which is perceived as a very highly valued expensive stock, its PE ratio based on its 2016 earnings estimates I believe was around 33 or 34 juxtapose that against Coca-Cola which its PE ratio was around 22 or 23 based on its 2016 earnings per share estimate.

So on the one hand you look and you compare simply the PE ratios of Facebook and Coca-Cola it seems that Facebook is much more highly valued, much more expensive than Coca-Cola when you’re simply at PE rations.  

However, the story does change a little bit when you’re looking at the PEG ratios of each of the companies.  

In the case of Facebook, its earnings growth over the next five years, expected earnings growth is somewhere north of about 30% per year thus giving its PEG ratio closer to about 1 versus Coca-Cola where its expected earnings growth over the next five years is pretty modest at perhaps 4% to 5% which would give Coca-Cola’s PEG ratio somewhere around 4.

So when you look at PEG ratios and how Wall Street is really valuing that growth, right now Coca-Cola is about 4 times as expensive as Facebook when you look at the company’s two PEG ratios.  

Again, PEG can give you a little bit of a different perspective in trying to assess relative value of stocks, and I think it’s a helpful tool to use in conjunction with other valuation metrics out there.

Steve Halpern:  Now, as you mentioned, you look at a number of different metrics, but in your latest issue -- based on the PEG ratio -- you highlighted two stocks that you found particularly attractive, Qualcomm (QCOM) and CBS (CBS).  Could you share your thoughts on these companies?

Chuck Carlson:  Yes.  I think both of them when you look at their PEG ratios relative to the universe of stocks that we cover here at Horizon Publishing -- which is about 4600 stocks -- those companies’ PEG ratios rank pretty attractively, certainly in the top half of that universe in terms of the value being demonstrated by the PEG ratio.  

I think both of the companies are interesting too from the standpoint they have both been beaten up pretty badly and I think they’re stocks that offering pretty interesting opportunities.  

In the case of CBS, it’s a media stock where there’s a lot of concern in that space about people cutting the cord and going over the top in terms doing streaming and things like that.

But I think at the end of the day, a company like CBS while they may be distributing their material in different modes going forward, they have content the people want, and ultimately, that’s a very important factor to have is having content.  

Their CBS network for example is the most watched network among the major networks.  The stock is trading at around $55 per share versus $64 at its 52-week high -- so it has come off the bottom. But I think from a valuation standpoint, it is still pretty attractive here at these prices.  

Qualcomm is a stock that’s had its bout with volatility and it’s been out of favor.  The 52-week high is around $72 and the stock is trading from $50 right now, but I think when you look at the total package here of the company it’s historically been a technology leader in the chip business.  

They have a sizeable business in terms of licensing fees off their technology.  They’ve got a very cash heavy balance sheet, which gives them a lot of flexibility to raise their dividend to buy back stock and to make acquisitions.  

You can get a dividend yield right now of over 4% in this stock, so I think when you look at all those valuation metrics they look pretty inexpensive, and then finally on the PEG ratio, it’s inexpensive as well.  

So these are two stocks which score well not just on PEG but other valuation schemes and ones that I think offer value right now for investors.  

Steve Halpern:  Again, our guest is Chuck Carlson of DRIP Investors.  I really appreciate your time today.

Chuck Carlson:  Thank you, Steven.  

By Chuck Carlson, Editor of DRIP Investor

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