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PEG is a common tool for finding stocks that may have low valuations compared to future growth. The basic rule of thumb is to have average annual earnings growth over the next 5 years roughly equal to the PE ratio. But this formula has its weaknesses. What are they and what is one method to overcome it?

PEG is Based on Rose-Colored Analyst Glasses

The PEG formula can be suspect to analyst overconfidence. Analysts might forecast earnings that will not be realistically achieved. The Globe and Mail reported that analysts tend to be optimistic in forecasting, with an average overestimation of 2.5%. This number is higher or lower depending on the certainty level (tracked by analyst dispersion and error of forecast versus actual). They report that some stocks have an overestimation factor as high as 34.3% at the beginning of the forecast period. This would be a major negative effect when trying to pick fairly valued growth stocks.

The Globe and Mail article discussed using trailing PE ratios in emerging markets to prevent the ‘rosy analyst’ effect. Overestimation of certain stocks will skew our PEG results since they are based on future growth estimates. How can we potentially reduce error?

Scanning For Low PEG Ratios with Greater Accuracy

Our scan will include low PEG ratios based on future expected growth, but also historical growth. This requires that a company be fairly valued when looking at past growth rates much like using both trailing and forward PE ratios.

Of course, this will remove smaller, potentially high-growth companies who have big dreams and forecasts but no earnings in the bank. This will give us a list of stocks of past growth performers with strong future upsides at good PEG valuations.

The Low Historical and Future PEG Ratios List

Company

Ticker

Price

PE

PEG (Historical)

PEG (Estimated)

Baidu.com, Inc.

(BIDU)

120.59

78.3

0.6

0.8

iRobot Corporation

(IRBT)(

28.88

30.1

0.6

1

Apple Inc.

(AAPL)

348.16

19.4

0.3

0.7

Ensign Group, Inc., The

(ENSG)

30.67

16

1

1

Super Micro Computer, Inc.

(SMCI)

15.2

18.8

0.9

1

Deckers Outdoor Corporation

(DECK)

88.3

21.9

0.6

0.7

Amtrust Financial Services, In

(AFSI)

19.23

8.2

0.3

0.7

Iconix Brand Group, Inc.

(ICON)

22.73

17.2

0.7

0.8

LHC Group, Inc.

(LHCG)

30.24

11

0.4

0.7

NVE Corporation

(NVEC)

59.15

21.7

0.5

0.8

SYNNEX Corporation

(SNX)

35.28

10.9

0.5

1

ZOLL Medical Corporation

(ZOLL)

46.68

49.7

0.9

1

There are a few surprises on the list. First, look how high some of the PE ratios are. BIDU is at 78, IRBT is at 30, and ZOLL pushing 50. The immediate reaction is to assume that these stocks must be highly overvalued. But when you look to the PEG ratios based on the past 5 years of growth and the expected 5 years of growth, these stocks hit the mark for being fairly valued.

Of course, be on the alert for new data. As an example LHCG just revised their 2011 estimates downward. This will have an impact on the PEG ratios once the new 5 year estimates are made by analysts.

Trends, Supports and Price Charts

  • LHCG just took a big price dump with the downward revisions. Caution is necessary. The upwards trendline is broken but prices are still above $26 support for now.
  • AFSI is near the upper portion of its upwards trending price channel.
  • NVEC has formed a double top around $62.50 and prices are consolidating near $58. 6 month momentum is still very strong.
  • IRBT, SNX, ZOLL, AAPL, and ICON are all strongly trending upwards.
  • ENSG has popped strongly since November.
  • BIDU retreated with some negative news recently that may not have strongly significant effects on earnings.
  • SMCI is toying with breaking above the $15.50 - $16 resistance and Deck is playing a range as it trends upwards in a bullish channel.

Historical and Future Ratios

As long as analysts overestimate earnings potential, much care will be necessary when using forward looking ratios such as PEG and forward PE. But by combining past history with future expectations, perhaps a more reliable valuation technique can be used when choosing growth stocks.

Source: 12 Low-PEG Stocks Historically Worth Their High Value