The PEG ratio

Once you understand how the PE ratio works, the question is how stocks in different industries can be compared. Different industries can experience different growth rates. It's not logical to compare the PE of a slow growth company to one that is growing at a rapid pace. After all, earnings growth is what drives stock prices higher. The PEG ratio solves this problem. It compares the PE ratio to the earnings growth of a company. So if XYZ company is trading at a PE of 10X and is growing earnings at 10% then the PEG would look like this: 10/10=1. What if XYZ fell on hard times and it's growth rate fell to 5%. Then the PEG would look like this: 10/5=2. Obviously the better value would be the PEG of 1, which indicates that you are paying 1X the growth rate rather than 2 times as in the second example. What would be an even better value? How about .5X the growth rate. So if XYZ had a growth spurt in earnings, say to 20%, then the PEG would look like this: 10/20=.5X . All we are really trying to determine is how expensive the stock is. Like any other purchase such as a house, car, even groceries, we don't want to overpay for the asset. Remember, buy low and sell high.

More on the P/E Ratio

                                                             
     One way I use the P/E ratio is to try to predict the future price of a stock. Lets say one company- XYZ corp. is trading at only 8 times earnings. Research shows other companies in this industry are trading at 14 times earnings. A little research shows that XYZ had a really bad quarter due to a bone-headed restructuring kind of like what happened to J.C Penny store. Suddenly, the board of directors got fed up and fired the CEO who created the mess. The new CEO restored order and people slowly returned to Pennys for their clothing needs. The old ratio looked like this P/E=Xm where stock price over earnings = a multiple of 8. I'll make up some numbers to fit, 16/2=8 where the stock was trading at 16 and the annual earnings was $2 which results in a multiple of 8X. Now that things have turned around for Pennys, I expect that their multiple will approach the industry norm. A little algebra will show that a multiple of 14X for Pennys will result in a stock price of  $32. X/2=16, solving for X yields the $32 stock price. Now this is very simplistic because it  doesn't take into account higher earnings due to the turnaround. Let's say the earnings increased to $3 in the year of the turnaround. Then a stock price of $48 could be expected. X/3=16- solving for X results in the $48 stock price. Notice that we are talking about comparing a company with peers in the same industry. My next discussion will allow us to compare valuations in different sectors which are growing at different rates. This is achieved with the PEG ratio which is the PE/growth comparison.





























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Exploiting the price/earnings ratio

                                                               INVESTING 101

     Today I am going to explain what I mean by "valuation". Valuation is expressed by the PE ratio. Simply stated, the PE is the price of a share of stock divided by the annual earnings of the stock. Lets say a stock was trading at $20 per share and its last years earnings was $2 per share, that would look like this as a ratio, 20/2 for a PE of 10. This is also called the multiple, because the 10 would have an X behind it. To understand this you have to consider just what the PE is telling you. Basically, the PE is saying how much you are willing to pay (price of the stock) for a dollar's worth of earnings. So in the example I gave, a multiple of 10X is saying that you would pay $10 for the right to earn $1. If that sounds silly, then consider that the average multiple of all stocks historically is around 12-15 times earnings. So a multiple of 10 is well within reason if the company has a viable business model.One such company is Whirlpool, the maker of washing machine,  dryers, refrigerators and other appliances. It was recently trading at less that 10 times earnings. Why? It has been punished for reducing its earnings guidance for the year to $12 from about $13. The stock is down 18% this year mostly due to a strong dollar vrs overseas currencies,mostly the Brazilian real (their currency). Bringing back overseas earnings to a strong dollar can diminish the earnings in dollar terms. I have my eye on Whirlpool but have not bought any yet because the pain may not be over. It is a good company suffering from its global exposure.
     In summary, the PE ratio is a valuable tool for comparing how expensive a stock is vrs other companies in the same business (sector). It can also be exploited in many ways to make investment decisions which I will discuss in later posts.

2016 FORECAST

January to June: .25% rate hike in fed funds rate. Takeaways: Not enough to interest fixed income investors. Stocks to remain strong while bonds will decline on bump and expectations of future rate hikes. Stocks will benefit from stronger dollar vrs other currencies due to massive inflow of foreign currency finding its way into U.S. market. July to Dec: oil to recover to $50 due to the destruction of Iraqi production by war on ISIS and Saudi curtailment. However, U.S. shale production will cap oil price for the foreseeable future. Takeaways: continue to invest in the consumer of oil such as airlines, trucking companies, delivery companies, plastic mfgs, refiners and agricultural companies. Look at low cost producers of oil with safe dividends to be added at a later date as advantage swings from fuel users to producers but stay with highest quality names like Exxon, Chevron, and Schlumberger. Select retailers will benefit from full employment and lower gas prices resulting in more disposable income: restaurants, department stores, cruise lines, hotel chains. Look for 10% growth in earnings and a PEG ratio of 1. Defensive positions as a hedge: Look to pharma, biotech, and low valuations. Buy on dips. Defense contractors will benefit because war is inevitable either directly or indirectly where U.S. supplies its proxies with weapons. Financials will benefit from a rate increase with improving net interest margins and housing recovery. Housing will recover slowly but rate of increases will determine the housing market. At 50 basis points a year, it will take 3 years to affect the housing market. Finally the baby boomers are dying-off. Invest in Service Corp Int. as millions opt to be cremated instead of conventional funerals.