Three Stocks Providing Cheap Growth Opportunities
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Investors are often puzzled when trying to decide a fair price to pay for a stock. Everybody agrees that high-growth companies deserve a higher valuation multiple, but quantifying the relationship between growth and valuation is not easy. The PEG ratio can be a handy tool for combining growth and valuation figures in one easy to analyze ratio.
The PEG (Price/Earnings to Growth) ratio is calculated by dividing a company's P/E ratio by its estimated growth rate. High-growth stocks deserve a higher P/E ratio, so the PEG ratio adds useful information by including growth into the analysis. It was Peter Lynch who popularized the rule of thumb of selecting companies that showed a PEG ratio below one. The famous investor wrote in his book One Up on Wall Street: "The P/E ratio of any company that's fairly priced will equal its growth rate," i.e., a fairly valued company will have its PEG equal to 1.
No financial ratio by itself can completely reflect the merits of an investment, but looking for companies with a PEG ratio below 1 can be a productive starting point to detect attractive opportunities backed by a quantitative analysis. Also, it is a good idea to check the PEG ratio of your holdings to have a mathematical view of the relationship between their valuation ratios and expected growth rates.
Apple (NASDAQ: AAPL), for example, has a surprisingly low PEG ratio of 0.74. Shares of the Cupertino giant have risen exponentially over recent years, so many investors believe that the company is too expensive based on that outstanding growth. But such an assessment is clearly a mistake -- Apple may have experienced an extraordinary return, but that doesn't make the company expensive in relationship to its fundamentals.
With a P/E ratio near 14, Apple is quite cheap in comparison to its expected growth rate of almost 19% per year over the next five years. Investors should also keep in mind that the company has done much better than that in the past, and although past performance is almost impossible to repeat, Apple has surprised investors and analysts by maintaining its extraordinary growth rates for longer than most would expect.
It looks like current concerns about the global economy have created a buying opportunity in Caterpillar (NYSE: CAT), which is trading at a PEG ratio barely above 0.6. Heavy machinery is quite sensible to the evolution of the economic cycle, and investors have good reasons to be worried about the march of the global economy over the coming months.
On the other hand, shares of Caterpillar seem to be already priced for a recession, trading at a forward P/E of 7.64. Even if next year turns out to be worse than expected by analysts it terms of earnings, there is not much downside room from a valuation perspective. Besides, Caterpillar is an industry leader with a very strong brand and wide geographical reach. Over the long term the company will be fine regardless of the economic cycle, so it looks like the current volatility may provide an opportunity to acquire some stock at a convenient entry point.
Those looking for less exposure to economic conditions in companies with low PEG ratios may want to consider Celgene (NASDAQ: CELG). The biotech sector doesn't depend much on the march of the economy, since they have the possibility to develop innovative and effective drugs regardless.
Celgene has developed many products for the treatment of different kinds of cancer, and the company has expanded via acquisitions like Pharmion and Abraxis, which solidify its position in oncology. Celgene is expected to produce almost 25% in annual earnings per share growth over the next five years, which is certainly challenging but not impossible in such an interesting industry. At a PEG ratio of 0.85, shares of Celgene still have considerable upside potential.
Investing is not an exact science; qualitative factors always need to be considered before making an investment decision. But these three companies have strong competitive positions and seem strong enough to keep growing nicely in the middle term. The fact that the numbers look good is clearly an additional positive factor to keep in mind.
acardenal owns shares of Apple. The Motley Fool owns shares of Apple. Motley Fool newsletter services recommend Apple. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.