By Carla Pasternak
You've likely heard of this valuation method countless times: The price-to-earnings (P/E) ratio that analysts use to compare a stock's current share price to its per-share earnings.
By this measure, stocks may appear "cheap." The benchmark S&P 500 now trades at a P/E of 14 times 2013's estimated earnings -- well below a long-term average of about 15.
But a low P/E doesn't always spell opportunity.
Consider Capital Products Partners (Nasdaq: CPLP) and Ship Finance International (NYSE: SFL), both in the oil-shipping industry. These stocks pay dividends and carry yields between 9% and 12%. Capital Products trades at 20.8 times 2013's estimated earnings of 37 cents per unit, while Ship Finance trades at just 9.2 times estimated earnings of $1.80 a share.
Which is the better deal? You're paying $9.20 for every dollar of Ship Finance's earnings but $20.80 for every dollar of Capital Product's earnings. All else equal, Ship Finance appears to give you more bang for your buck. Right?
It's not that easy. The P/E ratio simply tells you what investors are willing to pay for a stock's earnings. In fact, investors are often willing to pay more if these earnings are growing at a faster rate than other stocks in the same industry. So a company with a faster expected growth rate may trade at a higher P/E than one with lower growth expectations.
That's where the P/E and growth (PEG) ratio comes in handy. It combines the two measurements in one easy formula. You simply divide P/E by the earnings growth rate.
For this ratio, the P/E multiple can be based on next year's estimated earnings, this year's estimated earnings or trailing earnings for the past four quarters. I typically use a trailing P/E since it's based on actual earnings without built-in growth assumptions.
Generally speaking, stocks are fairly priced when the PEG ratio equals 1. A PEG of less than 1 is even better, while a PEG of more than 1 says you may be paying too much for the company's growth.
So let's take another look at Capital Product and Ship Finance. Analysts expect Ship Finance to grow next year's earnings at a steady 5.9% pace. In contrast, Capital Product's earnings are forecast to rocket 85% year over year.
Using the PEG formula, you can see that despite its higher P/E multiple, Capital Product offers better value. A trailing P/E of 5.1 divided by a 1-year growth of 85 gives it a PEG of just 0.06. By comparison, Ship Finance carries a PEG of 1.7 (10/5.9).
PEG is a handy tool, but it short-changes dividend-paying stocks that may grow more slowly because they pay out their earnings as dividends to investors. That's where PEGY comes to the rescue.
It provides a more complete measure of value for dividend stocks by adding the current dividend yield to the growth rate (You add the numbers only, without the percentage signs). The P/E is then divided by the sum of the two.
Ship Finance now looks more tempting with a PEGY of 0.6, once the 9.7% yield is factored into the equation (10/5.9+9.7). But Capital Product still offers superior value with a PEGY of 0.05, given an even better yield of 12.1% (5.1/85+12.1).
With this in mind, I combed the income universe for high-yield bargains with a 1-year PEGY of 1 or below. I identified stocks yielding at least 5% with an estimated 1-year growth rate of at least 9% and a P/E of 20 or less.
To avoid companies that offer high yields because of a falling share price, I further refined my search to stocks that had returned at least 5% year-to-date. After my extensive calculations, here's what I found...
As you can see from the list above, all the stocks I found were at least yielding 5% and sported a PEGY ratio of less than 1.
Each of these securities merits further research, but if I had to pick one, my first choice for further analysis would be the California-based business development company Hercules Technology Growth Capital (NYSE: HTGC).
Risks to Consider: Of course with investing, nothing is 100% certain. Just because a dividend stock has a low PEGY, it doesn't necessarily mean it's a stock worth buying.
But when it comes to buying dividend stocks, it's not enough to just look at the P/E ratio. There are a lot of other factors to consider, and one of the most important is the stock's PEGY. It's a good indicator of what you're paying for the company's earnings with respect to growth, and the stock's dividend yield.
Disclaimer: Carla Pasternak does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.