Pegging Down a Company’s Profit

Top portfolio managers like Peter Lynch place a good deal of stock in the PEG (price-to-earnings-to-growth) ratio, which is supposed to tell you how fully valued a company’s share price is.

Their reliance on this ratio is misplaced, however.

The PEG compares the company’s price-to-earnings (P/E) ratio with its earnings-per-share (EPS). It tells you what investors are willing to pay for every dollar of earnings the company brings in. The EPS tells you how much of the company’s profit is being budgeted to each share of outstanding stock and is thus a benchmark of company profitability.

A PEG higher than 3 is probably a sign that you should look elsewhere. A PEG below 1 could be telling you that the company is undervalued. You may be looking at a real gem … OR NOT. Instead, you may be looking at a company that had a one-time event that spiked income (like the sale of an asset or a tax break) or a one-time event that dropped income (like the closing of a plant). Either way, net income can be very misleading.

I prefer looking at cash flow (CF). It mainly consists of cash generated from operations. There are no write-offs or phantom income in cash flow. If CF is more than 10 percent of what investors are willing to pay for the stock, you’re looking at a company flush with money. Period.

You can punch up the PEG ratio on most stock screeners such as Yahoo! Finance. The price-to-cash-flow (P/CF) ratio is usually a no-show, but Reuters’ finance section includes it. And it’s worth paying attention to. This is the ratio that will give you a better insight into whether a company is a clunker or a potential big winner.

(Ed. Note: Andrew M. Gordon and his staff, along with Dr. Erik Epp, have created a new free e-letter called Money Insight: Useful Ideas for Growing Your Money Quickly and Safely. Every week, they decipher the best safe-money strategies from the deluge of mainstream financial news and uncover undervalued opportunities for quick profits. Check it out.)