What are we looking for?

A screen for dividend stocks that are cheap yet have strong earnings growth.

More about today's screen

We'll use PEG ratios again today. PEG stands for price/earnings to growth and is a ratio that helps investors figure out whether they're overpaying for a stock's earnings growth.

A week ago, we asked Morningstar CPMS to help us with a PEG screen for Canadian stocks and today we take that screen a step further for dividend stocks.

First, some more background. As we said a week ago, PEG is calculated by taking the P/E and dividing it by earnings growth. For instance, if a company's P/E is 10 and its earnings growth is 10 per cent, then its PEG would be 1. If the P/E were just five on earnings growth of 10 per cent, then the PEG would be 0.5. If the P/E were 20 on growth of 10 per cent then the PEG would be 2.

Lower PEGs are better if you want to buy cheap growth.

Morningstar CPMS, a Toronto-based equity research and portfolio analysis firm, maintains a database of about 660 of the largest and more liquid stocks in the country and spends a lot of time adjusting for unusual accounting items in each company's quarterly results to make sure screens can perform correctly.

After reading about the PEG screen last week, one reader, Biff Matthews, who is chairman of Manitou Investment Management Ltd., suggested the screen be adjusted for dividend stocks using what is called the PEGY ratio. This ratio is calculated by taking the P/E and dividing it by: five-year normalized earnings growth plus expected dividend yield (the Y in PEGY stands for yield).

Jamie Hynes, senior consultant at Morningstar CPMS, also added the following criteria to the screen: Stocks are selected from the S&P/TSX equity index, and limited to a maximum five stocks per sector and a dividend yield greater than 1 per cent.

CPMS uses five-year earnings growth normalized to remove unusual accounting items. Some readers wrote last week that using historical earnings can be misleading because historical results do not necessarily indicate future results. That might be true, but it's the best measurement we have. Few analysts forecast out more than two years and we want to make sure the screen isn't thrown off by short-term or temporary earnings fluctuations.

What did we find out?

Over the past year, the PEGY screen has done well, but not as well as the PEG screen. The PEGY screen returned 17 per cent over the past year, versus 11.6 per cent for the S&P/TSX total return index and 23 per cent for the PEG screen.

It's over the long term where PEGY shines.

"Simply reselecting the top 20 stocks based on the PEGY ratio annually produces an annualized return of 17.5 per cent versus 9.9 per cent for the S&P/TSX total return index and 13.7 per cent for the PEG ratio since Dec. 31, 1992," Mr. Hynes said.

(Stocks in this screen include: Rogers Communications , Fairfax Financial , Bombardier Inc. , Aecon Group Inc. , Home Capital Group , , Yamana Gold Inc. , Laurentian Bank , Genworth MI Canada Inc. , SNC-Lavalin Group Inc. , Cogeco Cable Inc. , Atco Ltd. , , Canadian Western Bank , WestJet Airlines Ltd. , Forzani Group Ltd. , CAE Inc. , Metro Inc. , TELUS Corp. and Saputo Inc. )