Ratio PEGs Projections To Reality
With profit growth unusually sluggish, the temptation to reach for stocks with strong long-term growth targets is understandable. But analystsâ€™ long-term projections tend to be wildly inaccurate, and the recent sell-off in overheated biotechnology and social media stocks has provided a fresh reminder of the dangers of overpaying for expected growth.
We compared S&P 1500 Index stocksâ€™ five-year growth estimates to actual profit growth for the following five years. Since 1994, stocks with the highest growth estimates have averaged higher growth than the average stock, but the relationship is not strong, and the targets rarely come close to actual growth.
The PEG ratio, which divides a stockâ€™s forward P/E ratio by projected annual earnings-per-share growth over the next five years, canâ€™t protect you from faulty long-term estimates. But PEG ratios can help uantify how much investors are willing to pay up for faster-growing companies. Since November 2011, P/E ratios have risen at a faster pace than long-term growth projections.
The average PEG ratio for the S&P 1500 Index was 1.83 at the end of December, its highest level in more than a decade. Since then, the average PEG has declined to 1.73, still above the 10-year average of 1.56.
In rolling 12-month periods over the last five years, the one-fifth of S&P 1500 stocks with the lowest PEG ratios outperformed by an average of 3.9%. Those returns suggest investors should be careful before they pay up for growth.
Interestingly, the PEG ratio is a decent indicator of future profit growth. The one-fifth of the S&P 1500 Index with the highest PEG ratios later averaged five-year per-share-profit growth of 24% — ahead of the 20% average growth for all stocks in the index. Stocks with the lowest PEG ratios averaged a 7% decline in EPS.
In rolling 12-month periods over the last five years, the one-fifth of S&P 1500 stocks with the highest PEG ratios outperformed by an average of 0.6%. Not bad, but nowhere close to the outperformance of low-PEG stocks, despite their lower profit growth.
Among more than 125 monitored uadrix factors, PEG ratio was the 12th-most effective over the last five years. Historically, low PEG ratios have had particularly strong predictive power in the materials, health-care, and financial sectors.
In the end, investors should not reach for operating growth without also considering a stockâ€™s price. Below we review four stocks with both attractive P/E ratios and high projected growth relative to their sector. The table below contains 15 such stocks.
At a glance, Continental Resources ($135; CLR) may not look like a Value stock. It earns a middling Value score of 52. Its trailing P/E ratio of 25 is 7% above the median for S&P 1500 exploration-and-production stocks. And its shares have returned 20% this year — double the 10% average total return for the S&P 1500 energy sector.Â
Through the prism of its expected growth, however, the stock looks like a bargain. Continentalâ€™s per-share profits are projected to surge 30% in 2014 and average 20% growth over the next five years. Its forward P/E ratio of 19 is 6% below its industry-group median, while its PEG ratio of 1.0 represents a 31% discount.
Continental owes the rosy outlook to its status as one of the largest independent oil producers in the U.S. With a substantial presence in the Bakken formation, Continental has grown proved reserves at an annualized rate of 47% during the past five years. Production growth has exceeded 39% in three straight years. Management seeks to triple both reserves and production by 2017 from 2012 levels. Continental Resources is a Long-Term Buy.
Express Scripts ($71; ESRX) earns a Value score of 85. It earns above-average ranks for more than 80% of uadrix Value factors and scores above 80 for 38% of Value factors, including the price/sales ratio, the most effective factor over the past decade.
Investors sometimes discount growth purchased via acuisitions, and that appears to be the case with Express Scripts, which bought Medco Health Solutions for $29.1 billion in April 2012. The shares look cheap relative to projected growth, with a forward P/E ratio below 14 (a 38% discount to the S&P 1500 health-care average) and a PEG ratio of 0.9 (a 45% discount). The consensus expects Express Scripts to grow per-share profits 14% in 2014 and 15% annualized over the next five years.
Express Scriptsâ€™ management promised to eventually reap $1 billion in annual savings from the Medco acuisition. It has already delivered improved efficiency, with operating profit margins expanding in each of the past six full uarters since the dealâ€™s completion. Express Scripts is a Buy and a Long-Term Buy.
Skyworks Solutionsâ€™ ($41; SWKS) stock has surged 57% since we first recommended it in November but still earns a respectable Value score of 67. A chief beneficiary of the rising demand for electronics devices to connect to each other, Skyworks has grown per-share profits, sales, and operating cash flow more than 7% in five consecutive uarters. But shares of the semiconductor maker look particularly attractive based on forward-looking estimates. Its PEG ratio of 0.9 is 43% below its sector average, reflecting an unusually low forward P/E ratio (31% below its sector average) and an above-average long-term profit-growth target of 17% (its sector averages 15%).
In the March uarter, Skyworks grew earnings per share 29% to $0.62, topping the consensus estimate of $0.59. Sales climbed 13% to $481 million, also ahead of the consensus. Looking ahead to the June uarter, management anticipates per-share profits of $0.73, up 35%, on revenue of $535 million, up 23%. At the time of the announcement, the consensus projected earnings of $0.63 and sales of $488 million.
In other news, the company said its first uarterly dividend of $0.11 per share will be payable May 22. SkyWorks announced the dividend in March but provided no date. The dividend euates to a yield of 1.1%. Skyworks Solutions is a Buy and a Long-Term Buy.
With a fleet of forklifts, power tools, and other construction euipment, United Rentals ($96; URI) enjoys a prime perch in the euipment-rental industry. Management said in January that the industry is in the early stages of a multiyear growth cycle, as commercial construction, accounting for roughly half of its business, begins to recover. United Rentals says euipment-rental rates rose 4.3% year-over-year in the March uarter, ahead of its full-year 2014 target of 4% growth.
On April 1, United Rentals completed its $780 million acuisition of National Pump, boosting exposure to the booming shale oil industry and the anticipatedÂ recovery in nonresidential construction. The deal adds about $210 million in annual revenue and lifts the specialty unit to 19% of total sales from 15%.
United Rentals plans to double the size of its higher-margin specialty unit in the next five years, mostly through organic growth. Efforts to grow its most-profitable business should help earnings rise at a healthy clip, even if sales growth (projected at 12% in 2014 and 9% in 2015) weakens in coming years. The consensus projects profit growth of 29% this year. United Rentals is a Focus List Buy and a Long-Term Buy.