Dykstra: Pegging a Stock's Momentum

While we all compare stats and opinions on who will make the playoffs this year, we know it often comes down to a team's momentum during the final weeks of the regular season. It looks like the Tennessee Titans picked up momentum Sunday in their win over the Steelers. And the Giants didn't disappoint either.

Momentum is also useful for evaluating stocks. Looking at a company's valuation by a single metric, such as the price-to-earnings (P/E) ratio, gives you a snapshot at a point in time. It tends to be a flat, blurry, black-and-white picture. It doesn't tell you much about whether that stock is on its way up, down or sideways. For that, you need three dimensions and something that adds color to the view overall.

A P/E ratio measures how cheap a stock is compared to other companies in its sector. I have always viewed stocks with a P/E of 15 or below as undervalued and candidates for a deep-in-the-money (DITM) options call. With the total market down 36% year to date, many P/Es have fallen below 15.

In addition to a stock's trading multiple, its growth momentum can be a big determinant of its value. Adding that third dimension -- growth -- to a P/E ratio can tell you a lot about its potential.

When you add the growth trajectory to a P/E, what you get is a PEG ratio: a P/E multiple divided by its expected rate of earnings growth. A stock is generally considered to be fairly priced when its P/E ratio equals its growth rate, which works out to a PEG ratio of 1 (for example, a P/E of 10 divided by an EPS growth rate of 10% equals 1). A PEG ratio below 1 is considered undervalued. The lower the PEG the better, as long as it's not in negative territory.