Chapter 2 issued warnings about screening on simple multiples like P/E. That came from an appreciation of what determines P/E: Not only expected earnings growth but also the risk to that growth. So, in buying a low P/E, one could just be loading up on risk. That, in turn, prompts warnings about trading on the PEG ratio, another investing screen. P/E and PEG screens must be checked with an analysis of the potential for growth and the risk that the growth will not be realized. The same warning applies to the P/B ratio: While P/B is determined by expected ROE in the future, it can be low because future ROE is at risk.
However, screening can help by filtering out stocks for that further analysis. There are many firms to which we can bring value investing analysis, and sorting out those where there might be payoff to the work involved would be helpful. You can be stimulated to investigate a firm by a number of catalysts: Recognizing the prospects of a business, recognizing good management, recognizing a promising business model, an insightful newspaper report, an analyst’s informed report, an unexplained drop in the stock price, and much more. But the chapter suggests other filters which can be combined with these filters to identify potential investing targets.
One is a low PEG with low indicated risk. The PEG ratio compares the forward P/E to a forecast of earnings growth in the near term. In effect, it challenges P/E with an (informed) growth estimate: If the P/E is low but the growth estimate is high (that is, PEG is low), that could be mispricing. That is a cue to investigate further. As the chapter informs, P/E could be low for a given growth because the expected growth is risky, discounting the price in the P/E ratio. So, a low PEG must be evaluated against the risk involved. Investigate further with a complete value investing analysis.
So, here’s the filter to help identify a promising stock to buy: A low PEG with indications that risk is low. And avoid stocks with high PEG and high perceived risk. That, of course, requires a risk indicator, a topic for later in the book. Chapter 2 refers to beta, not to be ignored but not a fundamental measure. Keep in mind that the integrity of the PEG ratio requires the earnings in the P/E to be sustainable earnings, not affected by one-time items that cannot grow. And a good estimate of future earnings growth is also important. The five-year estimate from analysts’ forecasts are not very accurate.
A similar cue can be given by the P/B ratio: A low P/B with a high forward ROE indicates possible mispricing. But, again, recognizing risk is crucial: P/B should be low if the risk to future ROE is high.
In January 2025, China Sunshine Paper Holdings Company Limited (2002.HK) traded at a P/E of 4.73, a P/B of 0.4, and an ROE of 9.2%. Worth looking into?