Navellier Growth: your source for market-beating growth stocks

 

When you listen to the financial TV channels or read Investor's Business Daily or The Wall Street Journal, one term that is used a lot when referring to stocks is Price to Earnings ratio or P/E ratio. It looks at how expensive the per-share earnings of a particular company are when compared to another similar company or the overall market. When conducting your own stock research, the P/E ratio itself is a very easy number to calculate. You simply take the company's price per share and divide by the annual earnings per share. For example, if Technogenius Incorporated earned $2 a share last year and had 20 million shares outstanding, the P/E Ratio is 10. In reality, you will almost never have to calculate this ratio since it is readily available in any newspaper or financial website that offer stock quotes.

Many traditional stock analysts maintain that the lower a company's P/E ratio, the better a value it is for investors. This would be true if all companies were the same. But, as anyone who looks at the broad scope of American business can tell, all companies are not alike. Some have a lot of debt, some have none, some are not growing sales and earnings year after year; others are growing very, very fast because of the new innovative goods or services they sell. Don't assume that just because Google's (GOOG) P/E ratio is 33 and Bank of America's (BAC) is 8 that the bank is a better buy. Google's earnings have been growing at over 80% a year while Bank of America grows at about 7%.

How to use P/E and PEG ratios

How, then, should one use Price to Earnings ratios when evaluating stocks? In recent years, a new way at looking at P/E ratios has developed. Rather then using it to compare to other stocks, it is evaluated in the context of how fast the company is able to grow earnings. This new way of looking at P/E ratios is known as Growth at a Reasonable Price, or GARP. GARP investors have developed a new ratio that helps them measure whether or not is expensive or undervalued by called the P/E to Growth or PEG ratio. This is simply the company's P/E Ratio divided by its growth rate. For example a company with a growth rate of 30% and a P/E of 30 would have a PEG ratio of one. The growth rate used is usually the forward growth rate as predicted by the stock analysts that follow it. A ratio of one is fairly valued and anything above that is considered overpriced. PEG Ratios under one are considered to be undervalued growth stocks that are probably attractive buys at the current price.

The trick is, when performing your own stock investment research, you should select stocks that have strong earnings growth and low P/E or PEG ratios. Take the stocks on my Emerging Growth Buy List, for instance. Our strategy at Emerging Growth is to find solid small- to mid-capitalization companies which we own for the long haul (at least a year so we get favorable tax benefits). I remain shocked at how low the valuations are for our Emerging Growth stocks–all of which are fundamentally solid companies!

When the overall stock market's earnings decelerated in the fourth quarter due to the housing crisis and massive financial write-downs, the earnings actually accelerated for our Emerging Growth stocks. Since February, our average forecasted price-to-earnings ratio has plummeted from approximately 18 times forecasted earnings to barely 15 times forecasted earnings! As a result, many of our Emerging Growth stocks have emerged as an oasis in a very confusing market environment. And they're the stocks rest of the market is seeking out.

Bottom Line: P/E and PEG ratios remain just one more tool in our stock-selecting arsenal. They provide further proof that growth stocks are cheaper relative to the overall stock market than they have been in years, and they are tremendous buys right now.

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