The #1 Secret of Great Value Investors - Investment Ideas

By Zacks | November 28, 2012 AAA

What if you could invest in a company that's not only undervalued but has the possibility of big growth?

I know what you're thinking. It's nearly impossible to find those stocks.

It's the "holy grail" of investing: a value stock that also has growth.

But here's a little secret that all great value investors know:

These holy grail stocks do exist.

And no, they're not some $1 stock with little volume or other risky fundamentals that are traded on an over-the-counter exchange. They are companies that you and I both know, but are, for whatever reason, being ignored by other investors.

Now that we know what the holy grail of investing is, how do we find them?

The #1 Secret is the PEG Ratio

Value investors have long looked to the price-to-earnings ratio (P/E) as a screen for value stocks. A low P/E ratio is believed to signify that a company is undervalued.

But that's not the only metric that signals value.

Benjamin Graham, long considered to be the "father" of value investing, found that a low price-to-earnings ratio wasn't enough to unearth the true undervalued companies. He looked to the PEG ratio instead, which combines both value and growth; a more potent combination.

The PEG ratio is calculated by taking the price-to-earnings (P/E) ratio and dividing it by the 5-year projected growth rate.

Confused yet?

These days you don't really need to figure it out yourself. Most financial web sites, including Zacks.com, provide the PEG ratio for you as a screening criterion when looking for stocks.

More . . .

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What's a Good PEG Ratio?

A company that is considered fairly valued will have a P/E ratio that equals its growth rate. So the PEG will equal 1.0.

A more expensive stock will be above 1.0.

Normally, a stock with a PEG ratio under 1.0 is considered "undervalued" as that means the market is underestimating the earnings, and/or it is growing faster than expected.

So, that's what you should be looking for when you see the PEG ratio. You want a ratio under 1.0.

How the PEG Ratio Really Works

1) You could have a company with a P/E ratio of 30 and a projected growth rate of 15%. This company clearly doesn't look like it's undervalued with a P/E ratio that high. You would be right. Plugging it into the formula, you get 30/15 = PEG of 2.0. Since 2.0 is above 1.0, it is considered an expensive stock.

2) Let's say you have a company with a P/E ratio of 40 and a projected growth rate of 50%. With a P/E of 40, it clearly seems to be a bad value. However, plugging it into the formula gives you a PEG ratio of 0.8 (40/50= 0.8). Since that is under 1.0, it is considered undervalued. The incredible growth rate counters the high P/E ratio.

3) In our third example, a company with a P/E ratio of 10, which is well within the value parameters for most investors and is usually considered pretty cheap, has a growth rate of just 7%. Putting it into the formula gets a PEG ratio of 1.43 (10/7= 1.43), which is much too high to be considered undervalued despite the company's rather low P/E.

Finding the Best Values

Instead of going it alone to find the values, we do the work for you. We offer a service that combines the most powerful value criteria like the PEG ratio with the timeliness of the Zacks Rank. It's a great way to catch value stocks at the right time - just as the market begins to recognize their real worth.

Today, in fact, our Value Investor portfolio includes 22 stocks that are "on sale," trading well below where they are likely to head in months and years to come.

What's more, I am getting ready to pull the trigger on new recommendations, and you will have the opportunity to climb aboard at the ground floor for the full ride upward. This is a value service, so I am glad to report that you can receive a substantial discount until Tuesday, December 4.

Find out more about the Zacks Value Investor portfolio >>

Good Investing,

Tracey

Tracey Ryniec is Zacks' Value Stock Strategist and is Editor in Charge of the Value Investor. You can also follow her on Twitter at @TraceyRyniec.

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