Overlooked Indicator Uncovers Screaming Bargains
One of the most important lessons I learned during my days in the Army was the KISS principle: Keep it simple, stupid.
Outside of the military, one of the greatest minds of all time believed in the KISS philosophy, but Albert Einstein expressed the idea in more poetic terms: “Everything should be made as simple as possible, but not simpler.”
I bring that same mindset to investment analysis. I want every process to be as simple as possible, but not so simple that I’m leaving out anything important. While I have spent a great deal of time studying complex investment techniques, what I discovered is that the KISS principle applies in investment analysis as well as it did in the military.
For example, although I look at complex valuation models, the simple PEG ratio consistently identifies undervalued stocks.
The PEG ratio compares the price-to-earnings (P/E) ratio to the growth rate of earnings per share (EPS). A stock is considered fairly valued when the PEG ratio is equal to 1, which means the P/E ratio equals the EPS growth rate.
I have found the PEG ratio to be a much more useful tool than other fundamental valuation methods for finding a stock’s fair value.
You see, with other popular valuation models like the P/E ratio and price-to-sales (P/S) ratio, we can only compare one stock to another, or see if it’s undervalued compared to its sector or the broader market. But that doesn’t really tell us whether a stock is actually undervalued; it only tells us whether that stock is undervalued compared to something else. Both stocks could potentially be overvalued, but one just less so than the other.
The PEG ratio recognizes that stocks with different EPS growth rates should trade with different P/E ratios. A company growing earnings at 40% a year deserves to trade with a higher P/E than a company with expected earnings growth of just 5% a year. The PEG ratio adapts to the company’s fundamentals, which makes it more useful than the more common “one size fits all” valuation approaches, such as buying when the P/E ratio is below some arbitrary number.
To quickly find a stock’s estimated fair value, we start with the basic formula:
As I mentioned above, a stock is considered to be trading at fair value when its PEG is equal to 1. Therefore, to find the fair value estimate for a stock, we can rewrite the formula as follows:
More important than this method’s simplicity is its reliability. Since I started my Income Trader advisory in February 2013, I’ve been using PEG to determine whether the stocks I’m recommending are undervalued.
In Income Trader, we sell put options on stocks we want to own. There are two main benefits to this strategy over buying shares outright:
1. We generate immediate income, known as premium, for selling the put option.
Depending on the price of the option and how many contracts we sell, this premium could range from a couple hundred to a couple thousand dollars per trade. This money is compensation for agreeing to purchase shares at the option’s strike price should they trade below that level before the option’s expiration date.
If the stock stays above the strike price through expiration, that income is ours to keep free and clear. But if it does fall below the strike, then we will be assigned 100 shares per contract at the option’s strike price, which brings me to the second benefit of selling puts…
2. We get to purchase stocks we want to own at a discount.
In addition to determining whether a stock is undervalued, I use PEG to define a wide margin of safety when selecting strike prices for our put options. And considering we’ve closed 105 straight profitable trades in just under three years, I’d say it works.
To illustrate its power, I want to walk you through a real trade in a stock I’ve had great success with: Gilead Sciences (NASDAQ: GILD).
This biopharmaceutical company develops drugs used to treat a variety of major diseases, but it is best known for its successful — and expensive — hepatitis C treatments.
The first time we sold puts on GILD was in January 2014, when shares were trading near $80. PEG put a fair value estimate for GILD at nearly $120, and I recommended readers sell puts with a $70 strike price for $105 per contract. The puts expired worthless two months later, so we kept that income.
Over the course of two years, we traded GILD a total of nine times, as the PEG ratio continued to show shares were undervalued.
Readers who sold just one contract each earned a total of $606. Readers who sold five contracts made $3,030, and those who sold 10 pocketed $6,060 — all without ever owning shares of GILD.
While shares are still undervalued by roughly 47% based on the PEG ratio, there is too much political uncertainty surrounding the biotech industry to enter a new trade right now. However, each week in Income Trader, I recommend a put selling opportunity to generate high income and potentially buy shares of a high-quality company at a big discount to current prices.
I understand many of you may still be leery of my strategy. But bear with me one more moment.
If you think selling puts is too complicated, I want to share a personal story with you: In this video, Profitable Trading customer service rep Emma Anderson shows you how she made $274 in two minutes.
After three years of listening to my Income Trader subscribers rave about how much money they were making selling options — $800… $2,000… even $5,700 or more every month — she decided to give it a try.
Emma is no trading expert. She’s a 32-year-old archaeology major. And, as she says, if she can do this, so can you. Click here to see exactly how Emma did it.