John Dorfman: Here’s another stock picking tool for your kit
Here's a stock picking tool you might not have thought about. It's called the PEG ratio.
The PEG ratio is a ratio of two ratios.
The numerator, or top line, is a stock's price/earnings ratio, expressed simply as a number. This is the stock's price divided by per-share earnings. If Superlative Entertainment shares sell for $40 and the company's profits are $4 a share, the price/earnings ratio is 10.
The denominator (divisor, or bottom number) is the stock's growth rate, expressed simply as a number. If Superlative Entertainment is growing its earnings at 20% a year, the denominator is 20.
So, Superlative Entertainment's PEG ratio would be 10 divided by 20, or 0.5. That's a very good ratio indeed.
The classic way to use the PEG ratio is to look for stocks with a PEG ratio less than 1.0. Only about 10% of U.S. stocks currently can jump that hurdle.
Here are five I think deserve consideration as buys.
Applied Materials
Applied Materials Inc. (AMAT), based in Santa Clara, Calif., is the world's second-largest maker of semiconductor manufacturing equipment. The largest is AMSL Holding NV (ASML), with headquarters in the Netherlands.
Applied Materials sells for about 19 times earnings, and its five-year earnings growth rate is about 21%. That produces a PEG ratio of 0.90. The question is whether the company has hit a wall. Last year, growth slowed to 3% for revenue and 6% for profits.
If the current trade tension between the U.S. and China turns into an outright trade war, it would slam Applied Materials, which gets a sizeable chunk of revenue from China. On balance, I think it's a risk worth taking.
Regeneron Pharmaceuticals Inc. (REGN), based in Tarrytown, N.Y., concentrates on drugs to combat eye disease, heart disease, cancer and inflammation. Its after-tax profit margin is a nice fat 33%. Its PEG ratio is 0.98.
Regeneron does sell some drugs in China, but I believe it would be less impacted by a potential trade war than most technology companies. The stock sells for about $757, and the average one-year target among Wall Street analysts is $1,093. Of 29 analysts who follow it, 21 rate it a "buy."
NVR Inc. (NVR) is a homebuilder whose stock I owned for about six years (2012-18). During that time, it was one of the best gainers I've ever had. I probably shouldn't have parted with it, since it's up 147% in the past five years.
NVR builds houses in 14 states but gets a lot of its revenue (about 22%) from the Washington, D.C., area. Under both Republican and Democratic administrations, the federal government has grown, helping to keep housing demand in the D.C. area strong.
In the past, excessive debt has been the Achilles heels of many homebuilders. Not NVR, though. It has $2.46 in cash for every dollar of debt, and debt is equal to only 24% of the company's net worth.
The PEG ratio NVR is 0.82.
Zoom Video
Many people got to know Zoom Video Communications Inc. (ZM) during the pandemic, while offices and schools went "remote" and people met "by Zoom." The company has more competition now than it did then, and the stock price is down 85% from the peak reached in 2020.
Nonetheless, Zoom's revenue for the latest fiscal year — $4.5 billion — is substantial, and considerably above the level at the height of the pandemic.
The PEG ratio is only 0.43. That's because many people feel the company's growth is in the past. Analysts are pessimistic. The stock stands at about $81, and the average analyst's guess is it will subside to about $77. I think the company might surprise to the upside.
Investors are enthralled with artificial intelligence. Making printers and selling the ink to refill them seems like an old-fashioned business by comparison.
Nonetheless, HP Inc. (HPQ) has achieved 14.5% growth in earnings the past five years. The stock sells for a price/earnings ratio of 12.9. That works out to a PEG ratio of 0.89, which gets me interested.
HP stock also has some dividend appeal. It yields 3% in dividends and has increased its dividend at a 14% annual clip the past three years.
PEG ratios are not easy to find. Gurufocus.com is one handy source; however, it charges a membership fee and calculates the ratio a bit differently than I do.
If you don't mind calculating the ratio yourself, you can find relevant figures in many places, such as Yahoo Finance, Forbes.com, Morningstar.com and the websites of many brokerage houses.
