PEG ratio 101- real life example in NFEC (PEG 0.12)
For newer investors...
Since burp and a few others have commented on the usefulness of the PEG ratio,(Price to Earnings to Growth), I’ve received a few PMs about it (“should I use that?”, “is it better than a PE”, etc.) so I thought I’d post a real life example that demonstrates just how useful this ratio is in discovering a fast grower before the market catches on- which is the essence of how to make money buying undervalued stocks from a fundamental approach.
I think everyone is comfortable with the PE ratio- it’s simply the stock price/earnings per share, and it’s a good start for valuation- but only the beginning. The PEG takes it to the next level and identifies stocks that are ramping up their net income quickly- which is the stock you want to buy. The general rule of thumb is that any company with forward growth that results in a PEG below 1 is probably undervalued.
The example I’m using is NFEC (NF Energy Saving Corp.) and I’m using it because it demonstrates perfectly how the PEG can be used and I’ve mentioned on the board that NFEC has one of the lowest PEG ratios of the stocks we discuss.
Because the PEG hones in on expected future growth and not historic as a trailing PE ratio does, it’s important to estimate what that future growth is with some degree of accuracy based on recent filings and press releases that tip you off to new sources of revenue/income that will hit the books in the coming quarters.
So in doing that, NFEC has reported a 65% increase in net income 2007-2008, with income growth accelerating to 100% in the most recent quarter reported in 2009. More importantly, looking forward for our future growth rate… since reporting q3, they have announced multiple deals for $15.5M in additional revenues to be realized between q4 of 2009 and q1 of 2010. That $15.5M in new contracts compares to the first 3 quarters of 2009 which combined was $15.2M.
So, in the last 3 months NFEC has inked deals that will be realized in q4 2009 and q1 2010 that exceed their total revenues reported so far in 2009 (!)
Based on the above facts, it’s reasonable (if not conservative) to say that the 100% net income growth in q3 2009 was not a fluke, and that will continue into q4 and q1 of 2010. Therefore, I’m using 100% net income growth in this calculation and believe that this may be understating their growth- but prefer to be conservative.
Taking NFEC’s current PE of 12.82 and dividing it by 100, you’ve got a PEG of 0.12, a stunningly low number that signals very fast forward growth that is presently undervalued by the market.
So to recap- the PEG is focused on the company’s forward projected growth, and garbage in = garbage out as they say. The key ingredient to the PEG is coming up with justifiable growth rates based on recent history and more importantly the future. If you have a company that is transparent and signals this growth as in this example, it’s not that difficult to calculate.
I hope this helps some of the newer investors here. One of the things I plan to do in 2010 is have periodic posts like this to help folks learn some of the ways to fundamentally value a stock for a buy and hold position. I think if you get the basics of fundamental analysis down and use that to pick your stocks, then use some basic technical analysis to help time your entry, you’ll make more money in the market than just reading a message board for stock tips or subscribing to some overpriced hype-machine publication.
It’s not by luck that some people make money in the market consistently and others don’t. It’s due to having more knowledge than your competition- which is the rest of the market. It does not ensure you’ll always pick winners- but it will swing the odds into your favor.
CSP
“The 19th century belonged to England, the 20th century belonged to the U.S., and the 21st century belongs to China. Invest accordingly.”
Warren Buffett
