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Using PEG As A Valuation Metric

One of the downsides of using a forward P/E ratio as a valuation metric is that it doesn't take into account growth rates. Generally, market participants are willing to price stocks at higher P/E multiples if they expect those stocks to grow earnings at a fast rate. The PEG Ratio is derived by dividing a stock's forward P/E by its expected earnings growth rate over the next 3-5 years. As such, it's a way to judge a stock's forward P/E in the context of its growth rate.

To illustrate the utility of the PEG ratio, consider two stocks, one with a forward P/E ratio of 10, and another with a forward P/E ratio of 30. Based solely on P/E, the first stock would be considered less expensive than the second. But what if the first stock was expected to grow its earnings at a 10% annual rate over the next 5 years, while the second stock was expected to grow its earnings by 30% over the same period? In that case, both stocks would have a PEG ratio of 1, which makes sense, since the second stock's higher P/E ratio is "justified" by its higher growth rate.

How High A PEG Ratio Is Too High?

Generally, a stock is considered inexpensive on a PEG basis if its PEG ratio is less than 1, but opinions differ on what PEG ratio, exactly, indicates that a stock is too expensive and should be sold or avoided. For portfolio manager and Seeking Alpha contributor David Merkel a PEG ratio greater than 1.5 marks a stock as too pricey; for CNBC's Jim Cramer, a PEG ratio of greater than 2 is too high.

The Risk Of High PEG Stocks

According to Jim Cramer (in the same article we linked to above), since value investors tend to find stocks with PEG ratios below 1 attractive, that creates a "risk floor," i.e., a PEG level where value investors might be expected to start buying. Growth investors, in contrast, may continue buying a stock while its PEG ratio rises up to 2. At times, stocks will trade at higher PEG ratios (as the stocks below are trading now), but Cramer's point here is that when these stocks stumble, there can be a lot of air below.

Five Stocks Overvalued on A PEG Basis

Using Fidelity's screener, I scanned for stocks with PEG ratios greater than 2.5, and market capitalizations below 20 billion (in order to spotlight some stocks that may not be as widely covered as mega caps.). In addition to the stocks in the table below - Netflix (NFLX), Alcoa (AA), First Niagara Financial (FNFG), Annaly Capital (NLY), and KeyCorp (KEY) - one of the most actively-traded names that made this screen was Power-One (PWER). I left it out of the table below due the buyout offer announced for it by ABB, Ltd (ABB) on Monday. Its PEG ratio is moot at this point. What matters for PWER shareholders is whether that buyout goes through, and, if it does, at what final price.

Note that Netflix beat earnings estimates and announced impressive subscriber growth on Monday, driving its shares up more than 19% after hours. Given that, I would expect analysts to raise their earnings estimates for the stock in the near future, which may lower its PEG ratio. I have kept it in the table below because, given its extremely high PEG ratio now, I expect it will still have a PEG ratio above 2.5 after analysts revise their estimates.

Name

Symbol

PEG Ratio

Netflix

NFLX

28.9

Alcoa

AA

5.92

First Niagara Fin.

FNFG

3.14

Annaly CapitalNLY2.64
KeyCorpKEY2.57

Ameliorating The Risk Of Owning These Stocks

For investors in these companies who are wary of the risks of holding them, but would rather not sell their shares at this point, we'll look at a couple of different ways they can hedge against significant declines over the next several months. To illustrate, we'll use one of these companies, Netflix, as an example. Then we'll show the costs of hedging the other stocks we've discussed here in the same manner.

Two Ways Of Hedging Netflix

Below are two ways a Netflix shareholder could have hedged 100 shares against a greater-than-20% drop between Monday's close and late September.

1) The first way uses optimal puts*; this way allows uncapped upside, but is more expensive. These were the optimal puts, as of Monday's close, for an investor looking to hedge 100 shares of NFLX against a greater-than-20% drop between then and September 20th (Since the stock moved significantly after hours, an investor looking to hedge the stock now should consider running a new scan for optimal hedges; however, these examples are useful for illustration purposes).

As you can see at the bottom of the screen capture above, the cost of this protection, as a percentage of position value, was quite high at 10.9%.

2) A NFLX investor interested in hedging against the same, greater-than-20% decline between Monday's close and late September, but also willing to cap his potential upside at 20% over that time frame, could have used the optimal collar** below to hedge instead.

As you can see at the bottom of the screen capture above, the net cost of this collar was negative, meaning the NFLX shareholder would have gotten paid to hedge in this case.

Note that, to be conservative, the cost of both hedges was calculated using the ask price for the optimal puts and the put leg of the optimal collar, and the bid price of the call leg of the optimal collar. In practice, an investor can often buy puts for some price less than the ask price (i.e., some price between the bid and ask) and sell calls for some price higher than the bid price (i.e., some price between the bid and the ask).

Hedging Costs For All Of The Names Mentioned Above

The table below shows the costs, as of Monday's close, of hedging all of the stocks mentioned above in a similar manner as NFLX above: first, with optimal puts against a >20% drop over the next several months; then, with optimal collars against the same percentage drop over the same time frame, while capping the potential upside at 20%. The SPDR S&P 500 ETF (SPY) was added to the table for comparison purposes. There were no optimal collars available for First Niagara or Annaly Capital given these parameters as of Monday's close.

Name

Symbol

Optimal Put Hedging Cost

Optimal Collar Hedging Cost

Netflix

NFLX

10.9%

-0.83%

Alcoa

AA

2.84%

1.60%

First Niagara Fin.

FNFG

15.1%

NA

Annaly CapitalNLY1.75%NA
KeyCorpKEY1.91%1.80%

SPDR S&P 500

SPY

0.52%

0.50%

*Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance PhD to sort through and analyze all of the available puts for your stocks and ETFs, scanning for the optimal ones.

**Optimal collars are the ones that will give you the level of protection you want at the lowest net cost, while not limiting your potential upside by more than you specify. The algorithm to scan for optimal collars was developed in conjunction with a post-doctoral fellow in the financial engineering department at Princeton University. The screen captures of optimal hedges above come from the Portfolio Armor iOS app.

Source: A Look At 5 Stocks Overvalued On A PEG Basis

Additional disclosure: I am long optimal puts on SPY, as a hedge against a market correction.