During the time of market volatility, investors often rely on value investing rather than other options like growth or momentum. As soon as other investors start selling their stocks at a cheaper rate, value investors take this as an opportunity to pick good stocks at a discounted price.
However, this apparently simple value investment technique has some drawbacks and not understanding the strategy properly may often lead to “value trapsâ€. In such a situation, these value picks start to underperform over the long run as the temporary problems, which once drove the share price down, turn out to be persistent. There are many value investment yardsticks such as dividend yield, P/E or P/B, which are simple and can single out whether a stock is trading at a discount.
However, for investors looking to escape such value traps, it is also vital to determine where the stock is headed in the next 12 to 24 months. Warren Buffett advises these investors to focus on the earnings growth potential of a stock. This is where lies the importance of a not-so-popular value investing metric, the PEG ratio.
The PEG ratio is defined as: (Price/ Earnings)/ Earnings Growth Rate
A lower PEG ratio is always better for value investors.
While P/E alone fails to identify a true value stock, PEG helps to find the intrinsic value of a stock.
Unfortunately, this ratio is often neglected due to investors’ limitation to calculate the future earnings growth rate of a stock.
There are some drawbacks to using the PEG ratio though. It doesn’t consider the very common situation of changing growth rates such as the forecast of the first three years at a very high growth rate, followed by a sustainable but lower growth rate in the long term.
Hence, PEG-based investing can turn out to be even more rewarding if some other relevant parameters are also taken into consideration.
Here are the screening criteria for a winning strategy:
PEG Ratio less than X Industry Median
