One fundamental analysis tool used by many investors called the forward PEG ratio. PEG stands for Price to Earnings Growth. As a relative valuation tool, the forward PEG ratio can help identify stocks that are currently priced below the company’s prospective long-term earnings growth rates. For medium-term investors, low forward PEG ratios may signal potential value if the company executes as expected and may also signal a limited downside risk.

The theory is pretty simple, along with the math. The basic premise is: 1) earnings drive share values and 2) most companies should be valued at 1.00 to 1.25 x long term earnings growth rates. If management increases earning per share by 10% and earns $1.00, the stock should be fairly valued at $10 and would have a PEG ratio of 1.0. If the share price is $5, the PEG ratio would be 0.5 and at $20 the PEG ratio would be 2.0. Utilities and income oriented stocks will usually have much higher PEG ratios. The forward PEG formula is: current PE divided by anticipated EPS growth rate.

Forward PEG ratios evaluate share prices based on anticipated earnings growth while a more traditional PEG ratio evaluates share prices based on recent and actual earnings growth.

When evaluating forward PEG ratios, fair value of large-caps should fall into the 0.9 to 1.1 range and small-caps up to 1.25. Stocks trading at a PEG ratio of 0.5 or less could be considered considerably undervalued and those above 2.0 as considerably overvalued.

Most stock screeners incorporate the forward PEG ratio as a criterion and can be easily incorporated into regular due diligence research. The PEG ratio is an excellent tool for valuation comparisons both with a specific industry and as a standalone tool.

For example, I used the following criteria in a search: member of either the DJIA or S&P 500, PEG ratio less than 0.75, minimum 5 year anticipated consensus earnings growth rate of 15%. There were about 27 companies that fit this simple search and mainly were from the autos, oil E&P, oil services, and financial sectors. Four seemed intriguing – Johnson Controls (NYSE:JCI), Harmon International (NYSE:HAR), Chevron (NYSE:CVX), and Travelers (NYSE:TRV).

JCI – PEG ratio 0.62, Market cap $22.5b, 2011 anticipated PE 12.5, anticipated 5-yr growth rate 28%.

HAR – PEG ratio 0.71, Market cap $2.5b, 2011 anticipated PE 12.5, anticipated 5-yr growth rate 30%.

CVX – PEG ratio 0.52, Market cap $168.9b, 2011 anticipated PE 8.3, anticipated 5-yr growth rate 18%.

TRV – PEG ratio 0.55, Market cap $25.6b, 2011 anticipated PE 9.1, anticipated 5-yr growth rate 15%.

Within the major integrated oil and gas sector, CVX’s PEG ratio is lower than ConocoPhillips (NYSEMKT:CQP) and PetroBras (BZE) at 0.58, ExxonMobil (NYSE:XOM) at 1.09 or BP (NYSE:BP) at 1.39. CVX could be considered undervalued both as a standalone company and within its industrial sector.

Based on their current low PEG ratios, JCI, HAR, CVX, and TRV should be worthy of further research by value investors.

I have been using the forward PEG ratio long before it was given a name. In the early 1970s (eons before the age of PCs and the Internet), I would research stocks by going to the library and reviewing Value Line. Value Line’s forte back then was publishing historical and future financials for thousands of companies. I would manually build a spreadsheet with lined paper and a calculator (high tech back then) comparing current PE ratios, anticipated PE ratios, and long-term growth rates. The goal of this exercise was to find companies that have not only earnings growth but PE expansion as well and to locate companies that were trading below the company’s long-term earnings growth rate. I have been using the forward PEG ratio for almost 40 years.

One weak link in a forward PEG ratio evaluation relates to the old saying – Junk In, Junk Out. The formula and strategy relies on someone’s crystal ball to foretell the future, much like the Zoltan Prophetron machine on the Coney Island boardwalk. If anticipated earnings and growth rates don’t materialize, the exercise is for naught. Low PEG ratios may also indicate current structural problems that may or may not get cured in the future. Consistent monitoring of the PEG ratio is usually suggested during periodical reviews of portfolio positions.

Investors should review forward PEG ratios as a valuation tool during their initial company due diligence. In addition, forward PEG ratios can be used to set individual price targets for each investment. If you are not currently using the PEG ratio, you may be missing a very quick, easy, and revealing fundamental evaluation tool.

**Disclosure:**No Positions