'Dirty 30' Evaluation Tool - Part 3

by: Cory Cook

Now that we are on to part 3 of the "Dirty 30" evaluation tool explanation, we begin to get to the meat and potatoes of what is truly being evaluated. While it is nice to see the potential gain (or loss) that I project with this tool, what lies beneath is really what matters. Let's begin with the "Current Comparative Values" section.

This section is typically what I run a lot of my initial screens from. While PE Ratio is not an end all be all, it can give a quick look into how exactly the stock is being perceived by the market. Go ahead and check out the comparative values section from Hormel (NYSE:HRL), and I will meet you on the other side.

P/E Ratio

As you can see, HRL is currently being valued by the market at a PE Ratio of 19.40. For those that do not know what the PE Ratio is, it is simply the current price of the stock divided by its earnings per share. The current average PE ratio of the S&P 500 is just over 25, well above its average of 15.68. For purposes of value investing, I typically like to see a stock being valued at around 15 or below. This means that the market may be overlooking, or even looking down on, this company, and that could mean it may be a value. Obviously, these values become increasingly rare when the market is booming, so being patient is key.

(Source)

Forward P/E Ratio

The next value that you come to is Forward PE Ratio. This is simply the current stock price divided by what analysts ESTIMATE the company's EPS to be next year. Remember that this is by no means a sure thing but is a decent indication into what paid analysts see for the future of the company (or industry). I also like to see this under 15. HRL has almost the exact same PE and Forward PE, which means that unless there is something significantly underappreciated by analysts, the future earnings of the company are not slated to improve much.

P/B Ratio

This may be where some of you out there may differ in opinion with me. In terms of a price to book ratio (current price divided by current book value per share), I like to see a real bargain of under 1.0. This means that I am actually buying the company for less than it's worth.

*Beware though that this usually means that there is something in the company that the market views as a problem or hurdle. A good example of this would be many of the retail companies, an industry that I believe the market is currently counting out even though it isn't there yet.*

For me, the 3.50 P/B ratio that HRL holds is a little much for me. That seems a bit overpriced, with the S&P average at 3.2 (although over the past 5 years, HRL has been valued at ~3.9 P/B).

P/S Ratio

Price to Sales Ratio, or the current price divided by per share revenue, is another statistic that I like to take a look at when screening stocks. Shown in the graph above is a back test ran by Zack Matras of Zacks.com that clearly shows the larger potential gains of purchasing stocks under a 1.0 P/S ratio. Obviously, that entails that you find the reason that they are currently priced that way and weigh out the risk/reward. There is always a reason that a stock seems undervalued. Finding out the true reason why is the tricky part.

PEG Ratio

Finally, this brings us to Price-to-Earnings-Growth ratio. This is calculated by taking the current price and dividing it by the projected rate of EPS growth. A PEG Ratio of under 1 means that the market is really failing to factor in future growth of the company. This means that you may have a potential steal on your hands. That being said, the reason that many companies are priced at a high PEG ratio is because the market believes that the future growth has potential to be much more than analysts expect.

As with any other valuation tool, PEG ratio cannot (and should not) be used alone when trying to place a valuation on a company.

Conclusion:

As you can see, the "Current Comparative Values" section is a very simplistic look at a 10,000 foot view of a stock. This obviously is just the tip of the iceberg in my valuation technique, but worry not friends, we will dig even deeper in part 4 next week.

As always, if you have any questions or comments please feel free to share.