One of the most important lessons I learned during my days in the Army was the KISS principle: Keep it simple, stupid.
Outside of the military, one of the greatest minds of all time believed in the KISS philosophy, but Albert Einstein expressed the idea in more poetic terms: "Everything should be made as simple as possible, but not simpler."
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I bring that same mindset to investment analysis. I want every process to be as simple as possible, but not so simple that I'm leaving out anything important. While I have spent a great deal of time studying complex investment techniques, what I discovered is that the KISS principle applies in investment analysis as well as it did in the military.For example, although I look at complex valuation models, the simple PEG ratio consistently identifies undervalued stocks.
The PEG ratio compares the price-to-earnings (P/E) ratio to the growth rate of earnings per share (EPS). A stock is considered fairly valued when the PEG ratio is equal to 1, which means the P/E ratio equals the EPS growth rate.
I have found the PEG ratio to be a much more useful tool than other fundamental valuation methods for finding a stock's fair value.
You see, with other popular valuation models like the P/E ratio and price-to-sales (P/S) ratio, we can only compare one stock to another or see if it's undervalued compared to its sector or the broader market. But that doesn't really tell us whether a stock is actually undervalued; it only tells us whether that stock is undervalued compared to something else. Both stocks could potentially be overvalued, but one just less so than the other.
The PEG ratio recognizes that stocks with different EPS growth rates should trade with different P/E ratios. Or to put it another way, a company growing earnings at 40% a year deserves to trade with a higher P/E than a company with expected earnings growth of just 5% a year.
The PEG ratio adapts to the company's fundamentals, which makes it more useful than the more common "one size fits all" valuation approaches, such as buying when the P/E ratio is below some arbitrary number.
To quickly find a stock's estimated fair value, we start with the basic formula:
As I mentioned above, a stock is considered to be trading at fair value when its PEG is equal to 1. Therefore, to find the fair value estimate for a stock, we can rewrite the formula as follows:
More important than this method's simplicity is its reliability. Since I started my Income Trader premium advisory in February 2013, I've been using PEG to determine whether the stocks I'm recommending are undervalued.
In Income Trader, we use options to earn income from stocks we want to own. And in keeping with the KISS principle, we use one of the simplest options strategies around to accomplish this -- selling put options.
There are two main benefits to selling put options over buying shares outright:
1. We generate immediate income, known as a premium, for selling the put option.
Depending on the price of the option and how many contracts we sell, this premium could range from a couple hundred to a couple thousand dollars per trade. This money is compensation for agreeing to purchase shares at the option's strike price should they trade below that level before the option's expiration date.
If the stock stays above the strike price through expiration, then that income is ours to keep free and clear. But if it does fall below the strike, then we will be assigned 100 shares per contract at the option's strike price, which brings me to the second benefit of selling puts...
2. We get to purchase stocks we want to own at a discount.
In addition to determining whether a stock is undervalued, I use PEG to define a wide margin of safety when selecting strike prices for our put options. And considering we've closed 105 straight profitable trades in just under three years, I'd say it works.
Use This Simple Strategy Again And Again...
To illustrate its power, I want to walk you through a real trade in a stock I've had great success with: Gilead Sciences (Nasdaq: GILD).
This biopharmaceutical company develops drugs used to treat a variety of major diseases, but it is best known for its successful -- and expensive -- hepatitis C treatments.
The first time we sold puts on GILD was in January 2014, when shares were trading near $80. My PEG analysis put a fair value estimate for GILD at nearly $120. So I recommended readers sell puts with a $70 strike price, which was not only below the price at the time, but far below the fair value estimate. This ensures that the odds of us having to purchase shares outright remain low. In return for this, we earned $105 per contract. The puts expired worthless two months later, so we kept that income.
Over the course of two years, as the PEG ratio continued to show shares were undervalued, we traded GILD a total of nine times.
Now here's another great thing about this strategy. It scales up nicely for those who want to earn even more income.
Readers who sold just one contract each time we made a trade earned a total of $606. Readers who sold five contracts made $3,030, and those who sold 10 pocketed $6,060 -- all without ever owning shares of GILD.
This Really Is The Simplest Way To Earn More Income
If the idea of selling put options is new to you, that's OK.
If you think it's too complicated, then I'm here to tell you it's not. In fact, in just a few minutes, you can be up and running, earning more income than you ever thought possible. I've prepared a full briefing that will tell you everything you need to know. To see just how easy this is, I encourage you to go here right now.
(This article originally appeared on StreetAuthority.com)