2 Great Stocks PEG-ged for Value

01/31/2012 7:45 am EST


Roy Ward

Chief Analyst, Cabot Benjamin Graham Value Investor

Finding great long-term investments is easy, if you've done huge amounts of groundwork and study...but now it's already done for you, writes J. Royden Ward of Cabot Benjamin Graham Value Letter.

How can you adapt what I have learned during the past several decades and create your own simplified investment approach? Very easy. I can get you on your way to steady, above-average profits using just two metrics: the Standard & Poor's Quality Ranking and the PEG ratio.

First, 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 dividend income and price appreciation upon which you can rely.

There is a very simple measure 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.

In addition to a high S&P Quality Ranking, I recommend using the PEG ratio to measure the degree to which a stock is undervalued. I use the ratio to find stocks selling at reasonable prices.

The PEG ratio is calculated by dividing the price-to-earnings (P/E) ratio by the earnings growth rate. Comparing PEG ratios will provide a good measure of which stocks are undervalued and selling at bargain prices.

The price used in the P/E ratio is the stock's recent price. 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 indicates that a stock is undervalued. The lowest PEG ratios are best.

Two good examples of high-quality companies with low PEG ratios are FedEx (FDX) and Universal Health (UHS). The companies have S&P Quality Rankings of B or better and PEG ratios of less than 1, meeting my objectives.

FedEx (FDX)

Standard & Poor's Quality Ranking for FedEx is B+, which indicates the company has produced steady earnings and dividend performance during the past five to ten years. My calculation of FedEx's PEG ratio of 0.85 is based upon the current stock price of $91.12, my forward 12-month earnings per share estimate of $6.54, and my estimated five-year earnings per share growth rate of 16.5%.

FDX provides worldwide on-time air express delivery for packages and freight in 220 countries, and door-to-door delivery of small packages in North America. The company also operates 1,200 copy centers (formerly Kinkos), which offer various business services.

Growth in the package shipping business is accelerating due to a rise in online shopping. The surge in demand has allowed FedEx to boost freight rates by 6.7% in September 2011 and another 5.9% in January 2012.

Most importantly, the US Postal Service (USPS), FedEx's competitor, will cut costs and services beginning in 2012 to balance its budget. USPS estimates most deliveries will take two to three days within the US, rather than the current one- to two-day delivery. Customers will likely rely more heavily on FedEx and UPS to handle important deliveries.

FedEx will spend $2 billion on new aircraft to fly to additional destinations. The expanded international operations will drive revenues and earnings growth in 2012 and beyond. Revenues will likely increase by 19% and EPS by 14% during the next 12 months. The company alsopays a small dividend.

Universal Health (UHS)

Standard & Poor's Quality Ranking for UHS is B+, which is a reflection of the company's strong balance sheet and steady earnings and dividend performance during the past ten years. My calculation of UHS's PEG ratio of 0.76 is based upon the current stock price of $41.45, my forward 12-month earnings per share estimate of $4.33, and my estimated five-year earnings per share growth rate of 12.7%.

UHS owns and operates acute care and surgical hospitals, and behavioral health, ambulatory surgery, and radiation oncology centers in 37 states.

The November 2010 acquisition of Psychiatric Solutions has provided a big boost to sales and earnings at Universal Health. In addition, the acquisition allows a better balance between acute care and behavioral health. Psychiatric Solutions has produced rapid growth, high occupancy rates, longer stays, and considerably lower uncompensated care.

Universal is expanding its outpatient services to help reduce health-care costs for patients. The company is also implementing efficiency programs to improve financial performance while enhancing patient satisfaction and outcomes.

We expect sales and earnings to increase 10% and 14% respectively during the next 12 months. UHS pays a small dividend, and the PEG ratio of 0.76 is very reasonable.

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