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Number Cruncher

How to PEG down cheap growth stocks Add to ...

What are we looking for?

Stocks that are cheap yet have strong earnings growth.

More about today's screen

Today we'll use PEG ratios; PEG stands for price/earnings to growth. This ratio helps investors determine whether they are overpaying for 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 5 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, will help with this screen today. Morningstar CPMS 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.

Jamie Hynes, a Morningstar CPMS senior consultant, ran a PEG screen using five-year earnings growth normalized to remove unusual accounting items. The screen had the following additional criteria: Stocks had to be selected from the S&P/TSX equity index, must have a P/E lower than the median in the index, a five-year EPS growth rate greater than the median of the index, and a standard deviation of five-year earnings growth lower than the median of the index. (By limiting standard deviation we can find stocks with relatively steady earnings growth.)

Mr. Hynes also selected a maximum of five stocks from each S&P/TSX sector. The P/E is based on forward earnings, that is, expected 2011 earnings for most companies. The result is a list of stocks originally selected on Dec. 31, 2009, updated with last Friday's prices. A backtest of this screen found that reselecting the top 20 PEG stocks going back to 1992 produced a 13.65 per cent annual return, compared with 9.94 per cent for the S&P/TSX total return index, Mr. Hynes said.

What did we find out?

If you believe Research In Motion Ltd. can keep growing, then here is another sign that this stock is cheap. Its annualized per year growth of normalized earnings (excluding unusual items) over the last five years is 96 per cent, yet its P/E is less than 10.

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