EL SEGUNDO, CA (September 2, 1999) -- The PEG screen and Formula 90 are similar strategies with outstanding results. They both use relative strength (price momentum) and earnings growth as the core of their stock selection process. In this article, we will examine the similarities and differences between the two strategies.
The first major component of both strategies is relative strength (RS). However, RS is computed differently for each strategy. PEG uses the Value Line (VL) 26-week total return as a measure of the relative strength of the stock. The VL 26-week total return is simply the percentage increase in price (split adjusted) plus any dividends or special returns over the past six months.
Formula 90, on the other hand, uses the Investor's Business Daily (IBD) RS number. Although the formula that IBD uses is proprietary, it seems to be something very much like the following weighted average:
0.4 x 13-week return + 0.2 x 26-week return + 0.2 x 39-week return + 0.2 x 52-week return.
All of the stocks in the IBD database are ranked by their weighted formula. The top one percent are given the RS rank of 99, the next one percent get ranked 98, etc.
Both The IBD RS and the Value Line total return have supporters. While I prefer the VL 26-week total return method, there is no conclusive evidence that proves one superior to the other. But both select stocks with strong recent price gains.
The second major component of both strategies is earnings growth. Again, these strategies have major differences in how growth is measured. PEG uses Value Line analysts' projected earnings growth for the stock. Formula 90 uses the IBD earnings per share (EPS) rating. While none of the workshop Fools has cracked the EPS formula, it is known that this formula is based solely on the past earnings of a company.
The PEG strategy uses Value Line's proprietary projections instead of the more widely known consensus projections. Consensus projections simply average the projections made by analysts at many different brokerages. Value Line's projections are independent estimates made without the biases that many of the Wise analysts have; therefore, VL projections tend to be more accurate.
Is it better to use past earnings or estimated future earnings? Intuition tells you that future earnings is what an investor cares about. However, many experienced investors believe that past earnings, not analyst's estimates, are a better indicator of future earnings.
Not only do these strategies use different RS and earnings growth indicators, but they also put the two together differently. Formula 90 starts with the Value Line Timeliness 1 stocks (a 100-stock database). It then eliminates any stock that is rated below 90 for RS and EPS by IBD. Therefore any stock that is not in the top 90% of both categories is out. The IBD RS rank is used to determine the five stocks to buy with the EPS rank used as the tiebreaker.
PEG starts with Value Line's Timeliness 1 and 2 stocks -- a larger base of 400 stocks. It ranks those stocks by the 26-week total return and selects the 25 stocks with the highest returns (6.25% of the database). Of those 25, only the 10 with the highest projected EPS growth rate make the next cut. That list is ranked by PEG ratio (P/E of the last 12 months divided by projected EPS growth) to determine the final four or five stocks. There is no equivalent to this step in Formula 90.
So which works better? Based on limited testing, it appears to be the PEG. However, when more testing is completed on the Formula 90, that may not hold up. Which will do better in the future? Only time will tell. But for now it looks like we have two excellent strategies from which to choose.