It's the Holy Grail of investing: a small yet rapidly-growing company, that manages to turn a profit and then just keeps on growing.
Buy in at the right time, and the right price, and you could easily have a multi-bagger' that is, a stock that returns your original investment many times over.
But how do you find such a stock? According to one of the biggest names in investing, Jim Slater, the answer depends heavily on one number the price/earnings to growth (PEG) ratio.
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It's incredibly simple to use. Yet applied correctly, it's one of the best ways to work out whether or not you have unearthed a bargain growth stock.
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Here's how it works.
Jim Slater's secret
"Elephants don't gallop." That's perhaps the most famous quote from Jim Slater - a banker, stock analyst, Telegraph columnist and author of investment bestseller, The Zulu Principle.
Slater's very simple point is that small companies can grow faster than big companies. He also likes them because they are poorly researched compared to bigger stocks, and therefore more likely to be underpriced and neglected by the wider market.
But how do you know if you've found a bargain or not, particularly when stocks are growing rapidly? This is where the PEG comes in.
Say we've found a stock with a price/earnings ratio of 30 (we looked at the p/e ratio earlier in the series).
Usually, if a company has a high p/e, the market is expecting it to grow fast. Otherwise, there's no way that anyone would be prepared to pay 30 times the currentearnings for it.
But is it cheap or not? Slater says the way to find out, is to compare the p/e ratio to the rate at which the firm's earnings are growing. This gives you the PEG.
Say profits are up 20% on the year. To find the PEG, you just divide the p/e ratio by this growth rate. So in this case, the PEG is 1.67 (30 divided by 20).
Is this cheap? No. PEG fans who also include well-known US investor Peter Lynch reckon that a firm's growth rate should roughly match its p/e.
In other words, a firm that can grow its earnings at 20% a year should have a p/e of about 20, just as a firm that can grow earnings at 30% a year should have a p/e of about 30. In each case, the firm's earnings are priced fairly.
So what you are ideally after as a bargain hunter is a firm with a PEG ratio of less than one.
For example if a firm expects to grow its earnings at, say, 20% a year, and its p/e ratio is 15, then the PEG is 15/20, or 0.75. That makes it a bit of a bargain you are getting a higher growth rate than its p/e ratio suggests.
To put together the PEG you'll need the latest p/e ratio. This is widely available on most investing websites - including ours- and is also published daily in the 'companies and markets' section of the Financial Times.
Next comes the slightly more complicated bit - you'll need a growth forecast. A good starting point is to compare the current year's earnings to the forecast for next year. Again you should be able to find these figures on most investment websites.
In simple terms, if earnings per share(which is just one year's profits divided by the number of shares in issue) for this financial year comes in at 10p, and is expected to rise to 12p for 2013, then the growth rate is 20%.
Of course, you should use more than one year's growth rate this might be a one-off. So ideally, you want an average growth rate based on figures going back at least three to five years (just add up the annual growth rates then divide by the number of data points to get the average). It's also worth looking at forecasts for future years.
What can go wrong?
Used in isolation, any ratio can be dangerous. The PEG is no different.
The main problem here is that it relies on an earnings growth forecast. These are prone to error, mainly because no one can predict the future reliably.
Unexpected events (new competition, a sudden lack of cashflow, or the loss of a key staff member) can hit small firms particularly hard, and completely alter an earnings forecast.
The PEG is also no use for analysing loss-making firms, where there is no expected earnings growth. But then again, investing in loss-making companies is a risky business that requires a completely different sort of analysis.
Also, this ratio works best on shares that are off the radar of the big analysts. Uncovering PEGs lower than one among well-known listed shares is tricky, as most earnings news is already 'in the price'.
So PEG fans need to be prepared to make an effort to hunt down stocks that other investors may have missed. But then, no-one ever got rich just by playing it safe and following the crowd.
Finally, it's worth remembering that the PEG is just based on a handy rule of thumb. There is no specific research to argue that the p/e ratio should be roughly equal to a company's earnings growth.
However, it is fair to say that the lower the PEG is, the cheaper the company. And if you can find small, fast-growing companies trading on PEGs of below one, they are certainly excellent candidates for doing further research.
If you are interested in small cap investing and you should be then sign up for our small cap specialist Tom Bulford's free email, Penny Sleuth. Tom's mission is to hunt down promising small businesses and tell his readers all about them. Also, his newsletter, Red Hot Penny Shares, is full of his best ideas and tips.
This article is taken from our beginners' guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here .
