Why settle for one-dimensional stock profits, when you can reap the benefits of a two-pronged attack? Growing earnings, coupled with an expanding P/E ratio, can produce serious gains for your portfolio.
Two simple steps will start your search. First, find companies that seem reasonably valued (or undervalued) relative to their growth rates, perhaps by comparing their P/Es to their expected EPS growth rates. Second, look how their current P/E compares with their average historical P/E.
Keeping your portfolio healthy
Let's apply this theory to the health-care sector. Suppose you're intrigued by medical-device maker Hospira's (NYSE: HSP ) booming sales of specialty injectable drugs, or the FDA approval it just received for a generic antibiotic. Hospira's P/E ratio is around 26 -- a little high, but it's close to the company's five-year average P/E of 27. The company seems somewhat fairly valued on this measure.
Its five-year expected growth rate is 12%. If its P/E stays relatively stable, you might see a total gain of about 75% over the next five years. That's not bad.
There's a better option
However, companies that seem more undervalued, and provide a greater margin of safety, can produce better performance. In the health-care sector, consider insurer WellPoint (NYSE: WLP ) , which sports a tantalizingly low P/E around 5. In fairness, a one-time gain from the sale of its NextRx pharmacy benefit management subsidiaries has made that number artificially low. Still, even with 2010 earnings estimates, the stock trades at an attractive multiple of just 8 -- considerably lower than its five-year average of 13. Like Hospira, WellPoint's also expected to grow at around 12% annually over the coming five years.
After five years, it would increase in value by the same 75% as Hospira. If its recent stock price near $50 holds steady, that would put its share price near $88 by 2015.
But wait! There's more!
As if that weren't impressive enough, remember that WellPoint's P/E is well below its five-year average of 13. If the stock's P/E catches up to its average level, its price could rise even further.
Suppose the company's earnings per share for this year are expected to be around $6.20. At 12% per year, those earnings will reach $10.90 in five years. If the P/E returns to 13 by then, the stock price -- at 13 times $10.90 -- will reach $141.70, giving you an increase of 184%. Suddenly, 75% growth looks downright puny.
Blue-chip growth
This one-two punch gets even more powerful when applied to fast-growing companies with steep average P/Es. But you don't need to gravitate toward aggressive candidates for your portfolio to earn solid returns.
If you crave safer, more established fare, the one-two punch can nonetheless make seemingly boring blue chips look a lot more exciting. Just consider any of these familiar names:
|
Company
|
5-Year Est. EPS Growth Rate
|
Recent P/E
|
Five-Year Avg. P/E
|
|
Medco Health Solutions (NYSE: MHS )
|
17.3%
|
20.6
|
25.6
|
|
Weight Watchers International
|
15.0%
|
11.0
|
19.3
|
|
Corning (NYSE: GLW )
|
13.4%
|
9.6
|
20.8
|
|
Blackrock (NYSE: BLK )
|
14.0%
|
18.9
|
31.9
|
|
Taiwan Semiconductor (NYSE: TSM )
|
15.0%
|
13.8
|
16.1
|
|
Wells Fargo (NYSE: WFC )
|
12.0%
|
10.9
|
19.7
|
Data: Morningstar.
Don't take on the stock market with one hand tied behind your back. Stocks that offer both earnings growth and P/E growth can help you rack up knockout returns over the long haul.
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