Despite the bullish run of the S&P/ASX 200 (ASX: XJO) (^AXJO) over the past two years, many investors will want to keep buying stocks. So what companies are expected to keep climbing and, perhaps more importantly, what is a good price to pay?
Depending on your timeframe and risk tolerance, there are still plenty of great opportunities to be had. Peter Lynch, a former fund manager who turned $18 million into $14 billion in 13 years, used simple "fourth grade" maths to do his valuations.
For example, one of his most popular gauges was the PEG ratio, or price/earnings to growth ratio. Simply it's the price-to-earnings Ratio (P/E) divided by the annual earnings per share (EPS) growth. For example, Westpac's (ASX: WBC) forecasted EPS growth in 2014 is 5.36% and the P/E ratio is 14.
Therefore the PEG ratio for Westpac is 14/5.36, or 2.6. A PEG above 1 means the stock is likely overvalued. A PEG ratio less than 1 means we can assume a stock is undervalued relative to its growth – although there are many other metrics that must be considered before a purchase takes place.
To understand it a little better, let's look at some other examples.
Westpac's rival ANZ (ASX: ANZ) currently trades on a similar profit multiple of 14. However brokers are expecting a bigger percentage of growth in 2014. According to Morningstar, EPS will grow by 16.6% in 2014, which gives it a PEG ratio of 0.84 (undervalued). However, as we know, there are plenty of other factors that need to be taken into account first. In my opinion, ANZ's current high share price and the vulnerability of many of the big banks' earnings make it too expensive to justify an investment.
Bentham IMF (ASX: IMF), a litigation funder, is one stock that could be a standout performer in coming years. It has an earnings growth forecast of 145% and trades on multiples of around 10.7. That gives it a PEG ratio of 0.07 (undervalued).
Small stocks provide more growth potential than their larger counterparts but they are also volatile and extremely susceptible to many different kinds of risk. Gage Roads Brewing (ASX: GRB) has a huge P/E ratio of 53 but its EPS is expected to jump from 0.2 cents to 0.7 cents next year. That gives it a PEG ratio of 0.2 (undervalued).
Let's take a look at a favourite for many investors interested in a solid growth story. Seek (ASX: SEK) shares, on face value, look expensive. They trade on 30 times earnings (P/E). However EPS is expected to grow 15% in the next year, giving the stock a PEG ratio of 2 (overvalued). In the long run, however, Seek's earnings are expected to continue growing so although it may not be a 'buy' for short-term traders, long-term investors could be satisfied with its upward trend and current price tag.
Foolish takeaway
Obviously a lot more goes into the valuation of a company's stock than a single technique and investors will have their own strategy to gauge an acceptable entry price. The PEG ratio can however be used in combination with other valuation techniques to get a better overall picture of a company's stock.
