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Look Out Below: Overvalued Stocks

By David Sterman

NEW YORK (TheStreet) -- A way to spot undervalued companies is to look for those with earnings growth rates that are higher than their price-to-earnings ratios.

They're known as low-PEG stocks, or stocks with a PEG ratio below 1. (For example, a P/E of 10, and an earnings growth rate of 20% yields a PEG ratio of 0.5, or 10 divided by 20.)

The converse is also true. Companies with high PEG ratios can be overvalued. They sometimes make compelling short-selling candidates.

So I went looking for companies that have P/E ratios that are at least twice as high as earnings growth rates. In other words, they have a PEG ratio above 2. On the table below, I've compiled a list of high-P/E stocks that show either small or negative profit growth forecasts for 2011. For most, profit growth is expected to turn negative next year, but the basic concept of a too-high PEG ratio still applies.

Akamai Technologies (AKAM) appears to be a poster child for high-PEG stocks. The provider of content delivery services is a good, but not great, growth story.

Over the years, an increasing number of companies have relied on Akamai to store content in local servers so Web sites can be pulled up quickly anywhere in the world. After years of erratic growth, the company is on track to boost sales and profits about 15% in 2011. Yet this has become a largely mature industry, price pressures are starting to bite, and the major telecom players are trying to steal market share, which is why analysts don't expect profit growth to exceed 10% to 15% in 2012 and beyond.

So why do shares trade for 33 times projected 2011 profits? Or said another way, does this stock deserve a PEG ratio above 2? Probably not. Instead, this is a classic example of a stock that becomes so hot, it's disconnected from the fundamentals. (Read 4 Stocks That Could Plummet in the Weeks Ahead.) Investors have been bidding up shares on expectations that a suitor for the company might emerge. Yet, the higher the shares rise, the harder it would become for a suitor to acquire the company without taking a big hit to earnings per share, as any deal would likely be quite dilutive. So if a deal fails to materialize, or investors start to see Akamai as a slowing-growth kind of company, the high P/E ratio would set shares up for a big fall.

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