Zacks Investment Ideas feature highlights: Apollo Group, Cirrus Logic and Vale
CHICAGO, Aug. 28, 2013 /PRNewswire/ -- Today, Zacks Investment Ideas feature highlights Features: Apollo Group (Nasdaq: APOL-Free Report), Cirrus Logic (Nasdaq: CRUS-Free Report) and Vale (NYSE: VALE-Free Report).
Beware the PEG Ratio
The PEG ratio is a simple tool that can be useful in your search for undervalued stocks. But it is far from a perfect metric and is no substitute for doing your own homework.
Before we examine its shortcomings, let's first explore what it is.
PEG Ratio Defined
The PEG ratio takes the basic price-to-earnings ratio one step further by factoring in earnings growth. In short, companies with faster earnings growth warrant higher P/E ratios.
This metric was first popularized by Peter Lynch and is calculated as:
According to Lynch, a company that's fairly priced will have a P/E ratio equal to its growth rate. In other words, a stock with a PEG ratio of 1.0 is fairly valued, while a stock with a PEG ratio of less than 1.0 is undervalued and a stock with a PEG ratio greater than 1.0 would be overvalued.
No Magic Bullet
While this seems intriguing and intuitive, remember it is only a rule of thumb. The assertion that a P/E ratio should equal earnings growth is somewhat arbitrary and certainly does not apply to all companies.
Consider a blue chip company operating in a mature industry. Its earnings growth may only be 5%. Does that mean it should have a P/E ratio of 5? What if it pays a huge dividend? What about a company with no growth... or even negative growth?
The intrinsic value of a business is the total of all its free cash flow available to owners discounted to the present value. This, of course, can be extremely difficult to calculate with any accuracy. So the PEG ratio is simply a proxy for it, and nothing more.
There is also no consensus on whether to use a trailing or a forward P/E ratio and whether to use next year's expected growth rate or a longer-term expected growth rate. But this can have a major impact on the PEG ratio calculation.
Beware Those 5-Year Growth Rates
I would argue for using a forward P/E since the stock market is forward looking, along with a longer-term earnings growth rate to keep a long-term perspective. However, use the long-term earnings number only with a great deal of caution. That is because the long-term earnings growth rates that analysts publish are often way too optimistic.
A study by J. Randall Woolridge and Patrick Cusatis of Penn State showed that analysts consistently project EPS growth rates much higher than actual growth and that companies rarely meet or exceed their projected EPS growth rates. In fact, over a period of more than 20 years, Woolridge and Cusatis found that analysts' long-term EPS growth forecasts averaged +14.7%, but companies actual long-term EPS growth averaged only +9.1% - almost 40% lower.
The study also found that analysts almost never forecast negative long-term EPS growth, although it happens quite frequently.
So do your own homework, and make sure those growth rates seem reasonable. Because many bad investment decisions have been made based on off-the-wall earnings growth projections.
3 Deceiving PEG Ratios
So what are some deceptively attractive PEG ratios out there right now? Here are 3:
PEG Ratio: 0.6
5-Yr Projected EPS Growth: 10.5%
Apollo Group owns several for-profit educational institutions including the University of Phoenix. A PEG ratio of 0.6 looks very attractive at first glance. However, if you look a little closer, enrollment, revenue, profit margins and earnings have all been moving in one direction for Apollo: down. In fact, based on current consensus estimates, analysts project a 20% decline in earnings for Apollo this year and a whopping 38% decline next year. It seems very unlikely that the company can get to 10.5% average EPS growth from there in just a couple of years.
PEG Ratio: 0.6
5-Yr Projected EPS Growth: 16.9%
Cirrus Logic develops high-precision analog and digital signal processing components for consumer entertainment electronics, including smartphones. A high tech company with a PEG ratio of 0.6 might sound alluring, but based on current consensus estimates, analysts project a 32% drop in earnings this year and a 30% drop next year. The company would have to right the ship very quickly to see anywhere near 16.9% average EPS growth over the next 5 years.
PEG Ratio: 0.4
5-Yr Projected EPS Growth: 20.4%
Vale is a metals and mining company headquartered in Brazil. A PEG ratio of 0.4 might be tempting, but investors will probably be wise to ignore its siren call. Based on current consensus estimates, analysts project a 5% drop in earnings for 2013 and a 12% drop in 2014. And those estimates have been declining for several months. It's very unlikely that Vale can compound its earnings at an average of more than 20% from here when earnings are expected to decline this year and next.
The Bottom Line
The PEG ratio can be a useful rule of thumb for finding undervalued securities. But it should only be a starting place in that search. Don't blindly rely on those published 5-year growth rates and do your own homework!
Zacks.com is a property of Zacks Investment Research, Inc., which was formed in 1978. The later formation of the Zacks Rank, a proprietary stock picking system; continues to outperform the market by nearly a 3 to 1 margin. The best way to unlock the profitable stock recommendations and market insights of Zacks Investment Research is through our free daily email newsletter; Profit from the Pros. In short, it's your steady flow of Profitable ideas GUARANTEED to be worth your time! Click here for your free subscription to Profit from the Pros.
Get the full Report on APOL – FREE
Get the full Report on CRUS – FREE
Get the full Report on VALE – FREE
Follow us on Twitter: http://twitter.com/ZacksResearch
Join us on Facebook: http://www.facebook.com/ZacksInvestmentResearch
Zacks Investment Research is under common control with affiliated entities (including a broker-dealer and an investment adviser), which may engage in transactions involving the foregoing securities for the clients of such affiliates.
Zacks Investment Research
800-767-3771 ext. 9339
Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Zacks Investment Research does not engage in investment banking, market making or asset management activities of any securities. These returns are from hypothetical portfolios consisting of stocks with Zacks Rank = 1 that were rebalanced monthly with zero transaction costs. These are not the returns of actual portfolios of stocks. The S&P 500 is an unmanaged index. Visit http://www.zacks.com/performance for information about the performance numbers displayed in this press release.
SOURCE Zacks Investment Research, Inc.
More by this Source
Browse our custom packages or build your own to meet your unique communications needs.
Learn about PR Newswire services
Request more information about PR Newswire products and services or call us at (888) 776-0942.