Fundamental Analysis 101

06/28/2013 9:45 am EST

Focus: STRATEGIES

Roy Ward

Chief Analyst, Cabot Benjamin Graham Value Investor

Low valuation is great, but investors should also look at a company's growth rate, says J. Royden Ward of Cabot Wealth Advisory.

A surefire method to find stocks to invest in that will outperform the stock market during the next year or two: ferret out stocks with low P/E to Growth (PEG) ratios and generous dividend yields.

I prefer to determine PEG ratios using the following method, because my method brings the dividend into the equation. First, let's look at the components. 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 lastly, the latest annual dividend yield.

Next, you can calculate the price-to-earnings ratio (P/E) by dividing the current stock price (P) by the latest four quarters of earnings per share. Then multiply the latest quarterly dividend by four to convert the quarterly amount to the annual dividend.

Then divide the annual dividend by the current price (P) to derive the annual dividend yield (D). Finally, divide the P/E ratio by the combined Growth and Dividend Yield to determine the PEG ratio. If you are using a computer spreadsheet, use the following formula to compute the PEG ratio:

PEG Ratio = SUM(P/E)/SUM(G+D)

Many investors do not include the dividend yield in the PEG ratio, but I believe my calculation is an excellent method to compare companies paying higher-than-average dividends. I like to think PEG ratios that include yields are used by the most intelligent investors!

In addition to low PEG 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.

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 ten 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 Web site. Just go to the stock research tab and enter S&P in the search box.

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.

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