In these days, the million-dollar question is “which stocks should I buy, or which should I sell?”.
There is a quick-and-easy indicator that anybody with basic screening knowledge can use. This indicator can be used in different ways, e.g., to identify which stocks are relatively cheap and could be a bargain or which stocks to avoid or sell as they seem overprized.
Growth premiums have sent equities to record highs over the last few years. For most of the stock market’s history, the typical P/E ratio was about 15. That means, investors were willing to pay a price equal to 15 times a stock’s annual earnings. The more growth potential a company shows for the future, the higher its P/E ratio will be. Considering a strong profit growth, a company with a P/E of 15 today would have one of just 10 tomorrow. It’s worth paying a “growth premium” to get into stocks of strong growth.
Thanks to artificially low interest rates, the last few years have been anything but typical, though. The multiple on the S&P 500 surged above 25, meaning investors expected a lot of growth. Obviously, things have changed now. We are in a recession, so our growth outlook is dim, and we might not see much for a while. That’s why stocks have fallen so far and so quickly. Growth expectations have been slashed, which pulls down the earnings multiple that investors are willing to pay.
But the market hasn’t slashed all growth expectations. There are plenty of stocks that still trade at tremendously high P/Es. The very first things we should be selling are stocks with sky-high earnings multiples that are unlikely to live up to their growth expectations. Anything with a P/E over 50 is suspect these days.
But be aware, just looking at an earnings multiple doesn’t tell us much about growth. That’s where the Price-Earnings-Growth (PEG) ratio indicators can help. It is simple because this growth-focused ratio merely divides a stock’s P/E ratio by its earnings growth rate. The higher the figure, the more growth there is priced in. A number below 1.0 represents a bargain. But for selling overpriced stocks, we should look at PEGs over 2.0. They represent a company with strong but probably too strong growth expectations.
Screen for stocks with a P/E over 50 and a PEG of 2.0 or higher and you identify stocks are most-likely overpriced and worth selling. They should be overpriced in a market where growth is hard to find.
Sven Franssen