In this article, we are trying a balanced approach to stock picking. We look for companies whose stocks are attractively valued compared to peers in the same industry and have solid growth ahead of them in the coming years. To measure valuation, we use a combination of PEG ratio and the next year's price/earnings ratio. The advantage of this valuation strategy is that the PEG ratio will help account for the growth in earnings, while the price/earnings multiple will help us gauge whether we are overpaying for the price. We restrict the PEG metric to less than or equal to one, and look for next year's price/earnings multiples that are less than that of the industry. To avoid troubled companies, we make sure that the price/earnings multiple is not too low.
For growth, we look at projections of earnings growth over varied time frames, such as estimated year-over-year EPS growths in this and the next year, and also earnings growth in the long term. Lastly, we narrow down the results by choosing only those stocks that have Buy or better ratings by analysts (such as First Call consensus ratings). Using this balanced approach, you will find the following stocks are selling below their projected growth prospects.
1. Rock Tenn Co. (RKT)
Rock Tenn is one of the largest makers of paper products used for packaging. The stock has more than doubled in the past year because of the recovering economy, and hence an increase in exports and demand for packaging products. Because of heavy reliance on the growth in exports and shipments, this company is highly GDP-sensitive. The company offers a dividend of 1.16%.
- Current price (as of May 7, 2013): $103.50
- Sector/Industry: Materials/Containers and Packaging
- P/E vs. Industry (next year's estimated): 11.4 vs. 12.9
- Price/Sales Ratio: 0.80
- PEG: 0.85
- EPS Growth (next vs. current year): 41.01%
- Forward EPS (long term, three to five years): 16.05%
- EPS Growth (this vs. previous year): 43.75%
2. China Telecom Corp. (CHA)
China Telecom provides a varied set of telecom services in most of China. These services include telephone, Internet, and wireless communication and managed data services. The subscriber base of China Telecom is expanding because of the growth in smartphone adoption. The total return of this stock is high, considering the 2.11% dividend it offers.
- Current price (as of May 7, 2013): $51.90
- Sector/Industry: Telecommunications/Diversified Telecommunication Services
- P/E vs. Industry (next year's estimated): 11.4 vs. 12.8
- Price/Sales Ratio: 0.92
- PEG: 0.94
- EPS Growth (next vs. current year): 25.26%
- Forward EPS (long term, three to five years): 16.90%
- EPS Growth (this vs. previous year): 25.02%
3. NRG Energy (NRG)
NRG Energy is a global power generation company that sells energy products worldwide. Majority of the company's stable cash flow comes from sale of capacity and generated power. NRG Energy acquired GenOn in 2012 for $1.7 billion a deal that is expected to contribute significant cost and revenue synergies to NRG. Thanks to this acquisition, an important growth catalyst for the company, NRG expects accretive revenues of about $200 million by 2014 along with annual savings of about $100 million in interest payments. Like most utility companies, NRG also offers a modest dividend (of 1.75%).
- Current price (as of May 7, 2013): $27.39
- Sector/Industry: Utilities/Independent Power Producers and Energy Traders
- P/E vs. Industry (next year's estimated): 19.4 vs. 28.8
- PEG: 1
- Price/Sales Ratio: 0.87
- EPS Growth (next vs. current year): 54.77%
- Forward EPS (long term, three to five years): 13.00%
- EPS Growth (this vs. previous year): 237.00%
Along with a couple of valuation metrics, earnings growth projections by analysts were used heavily in this stock-picking effort. Therefore, along with sector- and stock-specific risks, investors must weigh the risk of changing projections. To mitigate this risk, always remember to track growth projections proposed by analysts and forward-looking outlooks provided by the underlying companies.
In addition, remember that the markets are at record highs at present, and chasing stocks in current times is not the best idea. Rock Tenn, China Telecom, and NRG Energy seem attractive in the long run based on valuation and growth projections, but these are good picks to add to your shopping list for when the market pulls back.