Sivy’s Definition of an Undervalued Stock

Michael Sivy over at Money.com writes articles that I have referred to many times on my site. He has a good approach to investing that focuses on value. He also has the Sivy 70 which are his picks going way out into the future – mostly large dividend paying companies with good track records and good prospects.

His most recent article provides some guidelines on using this list and when stocks on it should be considered for purchase. I think these are valuable to look at:

To determine when a stock is undervalued, compare its price/earnings ratio, based on estimated results for the coming year, with the stock’s likely total return. You can approximate the annual return potential by adding the stock’s earnings growth rate to its yield.

This calculation is like the PEG ratio, which compares P/E with earnings growth. I prefer to add the dividend to the growth rate so that growth-and-income stocks can be fairly compared with pure growth stocks.

Ideally, the ratio should be less than 1.5. That means a stock with 10 percent earnings growth and a 2 percent yield should have a P/E no higher than 18. Obviously, a 15 or 16 P/E would be better.

A more aggressive stock – 15 percent earnings growth plus a 1 percent yield – should have a P/E no higher than 24.

This is no “magic formula” approach and requires the investor to do some work, but that is the point of investing. If you don’t understand the stocks you are in and their price relative to their earnings then you are not doing your job.