Double Your Dollars

Ever wondered how long it would take for a company to earn what you paid for its stock? A metric called the PEG payback period may have the answers you've been looking for.

Valuation and you
Studying the relationship between price, earnings, and growth rates can give you a fair idea of valuation. Earnings multiples like the forward P/E ratio look at the current share price, divided by expected earnings per share. The PEG ratio, in turn, compares that forward P/E ratio to the company's expected earnings growth rate. Although there are some quirks in using PEG ratios, PEGs below 1.0 suggest undervaluation, while those above 1.0 reflect an overvalued stock.

Although the computation is tricky, the PEG payback period reflects how long it should take for a company's growing earnings to generate enough to total the sum of your original investment. In other words, if you pay $15 for a share of Company X, the PEG payback period will show you how long it will take that company to produce $15 in earnings per share. Morningstar argues that this period also shows you how long it would take you to double your money on your stock, from an earnings perspective.

Reading the numbers
PEG payback periods can be helpful as you compare investment candidates. The table below illustrates some of the variation among Dow components:

Source: Motley Fool CAPS and Morningstar.

Don't assume that the payback period is only about time. Pfizer's short payback period might look like the most attractive company above at first glance, with Cisco Systems as the next most attractive. But part of your payback period evaluation should consider risk.

Right now, Pfizer has lots of drugs in its promising pipeline. But 5.5 years from now, some of its big drugs, including the blockbuster Lipitor, will no longer be protected by their patents. Pfizer will need new smash hits to quickly replace them. Cisco, meanwhile, operates in an industry that changes very quickly. That makes it hard to know what companies like Cisco will be doing in five or 10 years.

DuPont and General Electric also face changes in various arenas in which they compete. But each is very diversified, and each pursues more stable businesses, such as appliances and engines (GE) and construction and countertops (DuPont).

Low numbers
If you're itching to see how low payback periods can go, here are a few companies with particularly short time spans:

Source: Motley Fool CAPS and Morningstar.

The first three all have PEGs well below 1.0, which makes them look significantly undervalued. It's true that they're mostly in fast-changing industries, but the PEG payback period offers some comfort that they're growing rapidly enough to compensate for that, at least to some degree. A-Power Energy is a small, China-based wind turbine maker; Micron Technology is a big semiconductor company; and China Electric Motor does exactly what its name suggests.

Micron Technology has its fans and foes, but it appears to be inexpensive enough to offer a substantial margin of safety. Meanwhile, mortgage REIT Newcastle has such a low P/E that it takes almost no time to earn it back. However, its earnings may be peaking in the current interest rate environment.

The more you know
The PEG payback ratio isn't a silver bullet to solve all your investing problems. Like other tools, this one relies quite a bit on estimates -- which may prove to be at least a little off-base. But still, it can be helpful as you assess a company and compare it with others. Consider adding it to your toolbox as you look for irresistible bargains.

If fast-growing companies make you nervous, just grow wealthy with hefty dividend payers.