Putting a value on stocks

The essence of my method of determining if growth shares are over- or under-valued by the stock market is to compare the growth rate with the price/earnings ratio. I find it convenient to establish a price/earnings growth (PEG) factor by dividing the future growth rate into the prospective p/e ratio. For example, a company growing at 20 per cent per annum on a multiple of 26 has a PEG of 1.3, which is about the same as the average growth share.

If the PEG is under 1, a growth share catches my attention. At under 0.66, I begin to think I have found a bargain, provided it also fulfils a number of other selective criteria such as having a competitive advantage and a strong balance sheet.

For the year ahead, most brokers believe that the market as a whole is on a prospective p/e ratio of under 14. To achieve this, next year's earnings growth should be in the region of 16 per cent. Dividing this figure into 14 gives an average PEG of 0.9, which seems to be unusually attractive for the market as a whole. However, the overall figures are a little misleading because they include a large element of recovery (as opposed to growth). The PEG is more effective as a measure for comparing growth stocks that are adding future growth to past growth. The system is at its best with growth stocks in medium-sized companies with prospective p/e ratios in the 12-16 range and with growth rates of 20-25 per cent. Low p/e ratios provide some protection against the downside risk and the high growth rates give the scope for substantial future gains. For example, a share costing 130p on a multiple of 13 with earnings per share of 10p and a growth rate of 20 per cent per annum would have a PEG of 0.65. Over a period of 12 months, after 20 per cent growth and with the same rate forecast for the following year, the multiple could easily rise to 20. In that event, on future EPS of 12p, the share price would increase to 240p (20 x 12p) compared with the original cost of 130p (13 x 10p).

Another important factor is that the PEG method is essentially arithmetical. It picks out shares with anomalously low p/e ratios and relies upon the company's management, who have produced above-average earnings growth in the past, to continue doing so.

In recent months, the problems of Sage and Micro Focus have made me reconsider my investment criteria. As a result, I have decided to exclude computer software companies from my selections.

Fortunes will no doubt continue to be made by timely investment in software companies, but their technology is changing so fast that today's wonder products can suddenly become of historic interest only.

Turning now to Sage and Micro Focus, if you bought either on my recommendation, you should by now have cut your losses. As you know, I advise you to cut losses if the story changes very much for the worse or if shares fall more than 25 per cent below the highest price they have touched since you bought at my suggestion.

I recommended Sage in March when the share price was 567p. In the following months the shares rose to 629p before falling back to about 420p after a mild profits warning for this year only; the shares then drifted back to a low of 367p. Since then there has been some director share-buying and a new range of products has been announced. As a result, the shares have risen to 453p, so you were fortunate if you missed selling at the first opportunity after the profits warning.

In the case of Micro Focus, I recommended the shares at pounds 20.73p and they subsequently rose to pounds 21. The shares then began to drift downwards. There was no warning from the board - only a downgrading by an American broker. As you can see, 25 per cent off pounds 21 gives pounds 15.75, at which price the automatic stop-loss should have come into operation. The shares fell well below this for a few days, but have since recovered to pounds 15.35 following a statement by the directors that the American broker's circular was not based on information supplied by the company.

If you still hold shares in Sage and Micro Focus, you have a more difficult decision to make today than if you had simply applied the automatic stop-loss. Both have strong management, a place in their markets and substantial cash balances. They could easily recover and on past performance may again prove to be excellent investments.

However, I sold my shares on their poor relative strength, as I believe in cutting losses however painful they may be, and I also believe in running profits.

That way you end up with a number of small losses more than offset by some very large profits.

The author is an active investor who may hold any shares he recommends in this column. Shares can go down as well as up. He has agreed not to deal in a share within six weeks before and after any mention in this column.