On Wall Street, growth stocks achieve premium valuations, but identifying a fair price for that growth can be challenging. Traditional metrics like the PEG (Price/Earnings to Growth) ratio have been widely used to gauge if a stock is overpriced relative to its growth potential. However, while useful, the PEG ratio has significant shortcomings. For example, it assumes a linear relationship between growth rates and earnings, which oversimplifies the compounding effect on earnings over time. Moreover, PEG fails to account for dividends, undervaluing companies that return money to shareholders instead of reinvesting in growth. To address these issues, a new metric called Super PEG is proposed, which offers a more nuanced approach to evaluating growth relative to market price.
The Super PEG measurement diverges from the traditional model by assessing how much is paid now to unlock future earning potential, which is then compared to investment in the S&P 500 index. This provides a clearer picture of whether a stock is a genuine bargain relative to broader market expectations. The calculation is versatile, allowing analysts to insert various timeframes for estimating future earnings growth. In the analysis that follows, the Super PEG approach identifies twenty currently undervalued stocks that could offer significant long-term value, particularly if they sustain their recent growth rates. This list includes a diverse collection of companies, including homebuilders and auto parts dealers, that have been overlooked by the market.
The traditional PEG model is straightforward in its calculations, making it accessible for many investors. For example, if Hershey’s has a price/earnings ratio of 20 and an expected earnings growth rate of 5%, the PEG ratio is calculated as 4, indicating potential overvaluation. The ideal PEG ratio is 1 or lower. However, the simplicity of this calculation is a double-edged sword; it does not hold up against the complexities of real-world market dynamics and growth trajectories. These shortcomings call for a more advanced methodology that considers the effects of compounding and shareholder returns more effectively.
Super PEG rectifies the weaknesses of the classical PEG model by integrating a comprehensive assessment of a company’s growth capabilities, dividends included. It uses a conservative five-year outlook, where it begins with an analysis of the EPS growth over the past decade and projects that growth into the near future while accounting for a regression to the mean market growth rates. The measure is designed to highlight stocks that are mispriced according to their potential future earnings, offering actionable insight into stocks that the market currently views unfavorably.
The list of undervalued stocks derived from Super PEG highlights several sectors, notably homebuilding, where companies like Toll Brothers and Lennar have surfaced. Other companies in the list signify a market skepticism towards traditional combustion engine vehicles, such as Penske Auto Group and Snap-on, indicating investor trepidation concerning the future of these industries. Investors must remain cautious, however, as history shows that low valuations might not always equate to performance rebounds, necessitating a critical examination of the rationale behind the market’s current disfavor.
Conversely, the analysis also identifies stocks that appear expensive according to Super PEG, effectively challenging investor confidence. Companies that have sustained high growth rates are examined under this model, highlighting potential pitfalls in assessing long-term value. Fast-growing entities often receive optimism for continued success, yet it remains crucial to scrutinize the sustainability of growth rates that lead to disproportionately high valuations. Through this lens, investors can better navigate the complexities of the market and make informed decisions about which stocks to pursue based on their true earning potential, rather than relying solely on traditional metrics that might lead to mispriced assessments.
