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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 stock growing earnings at 40% a year deserves to trade with a higher P/E than a stock 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, then 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 85 straight profitable trades over those two 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, from the flu to HIV. But two of its most successful (and expensive) drugs are for the treatment of hepatitis C.
GILD offers a combination of value, volatility and safety that makes it an excellent income trade.
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 a year, we traded GILD a total of five times, as the PEG ratio continued to show shares were undervalued.
Readers who sold just one contract each earned a total of $360. Readers who sold five contracts made $1,800, and those who sold 10 pocketed $3,600 -- all without ever owning shares of GILD.
Last week, Gilead reported blowout earnings. Despite triple-digit revenue growth and a new dividend, investors were spooked when they heard the company would be discounting its billion-dollar hepatitis C treatments, which accounted for nearly half of last year's sales, more than expected. The stock sold off more than 8% the next day.
Rather than waiting for analysts to prepare new estimates, I decided to forecast the worst-case scenario for this highly profitable company.
Analysts had been expecting a little more than $28.6 billion in revenue for 2015, but management said full-year revenue could be as low as $26 billion, nearly 10% lower than expected.
Analysts had also been expecting 2015 EPS of $9.84. To create a worst-case scenario, I assumed that the full drop in sales would be reflected in the bottom line. Reducing the original $9.84 estimate by 10%, I got a new estimate of about $8.85.
At the time of the earnings release, analysts had expected GILD to grow EPS at an average rate of 33.4% a year for the next five years. That growth estimate has since been revised to 25.2%, but let's assume it falls even further to half of the original consensus. That gives us a worst-case growth rate of 16.7%.
Using a P/E ratio of 16.7 and estimated 2015 EPS of $8.85, the fair value of GILD based on the PEG ratio would be about $147, which is more than 45% above current prices.
So, for the sixth time, I decided to sell puts on GILD, this time recommending the March $85 strike, which brought in another $65 per contract.
A put selling strategy makes it possible to generate high income and could provide an opportunity to buy shares of this leading biopharmaceutical company at a big discount to current prices.
Following the post-earnings sell-off, shares rebounded from support near $95. They are now trading 19% above our strike price, and the premium for our option declined significantly in the past week. This is a good thing for us, but it also means it's too late to enter this particular trade.
But I have put together an eight-minute tutorial explaining step by step what you need to do to start collecting income from other stocks. In it, I detail how I've used this strategy with a 100% win rate and generated average annualized gains of 53%.
If you're interested in using put options to generate instant income, then I encourage you to watch this short training video. View it here for free (and see how to make anywhere from $45 to $1,300 this week).
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