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A Word On Valuation

Now that a speculative edge has returned to the stock market again, it's probably a good time to look at some basic measures of valuation.

If you're a gun-slinging day trader who cares only about the technicals, this column's probably not for you. And if you're an experienced investor, you may not find much here that's news to you either.

But if you're socking away hard-earned money for retirement or the kids' education, it's probably a good time to stop and think about valuation for a moment.

We'll start with the PEG, or price-to-earnings growth ratio, a tool so simple that anyone can use it. A look at PEG ratios on just a few leading Net issues is eye-opening here.

To calculate the PEG ratio, you need only two things: the price-to-earnings ratio, or PE, and the growth rate. We'll give you one link to calculate both in just a moment. The PEG should probably be calculated based on one-year trailing earnings, but given that many Net stocks are just entering profitability, we'll use current fiscal year estimates.

Let's start with Juniper Networks , the emerging leader in the high-speed router space. The company is expected to earn 95 cents a share for the year ending in December. At a current price of about $66 a share, that gives Juniper a PE of 69.5 based on this year's earnings estimates (66 divided by .95).

In an ideal world, then, you want a long-term growth rate of 70% to get the desired price-to-earnings growth ratio (PEG) of 1 or lower on the stock. Is Juniper going to grow at a 70% rate in coming years? Not according to analysts, who are a notoriously optimistic bunch. The company is expected to grow earnings 80% this year and 25% next year, so we'll give it a two-year earnings growth rate of 52.5%. So you probably don't want to pay more than 52.5 times earnings for Juniper if you're doing anything more than trading the stock. That makes Juniper a buy at 49.88 or lower.

Here's a single link to calculate the PEG on any stock you own; just change "jnpr" in the following URL to the ticker symbol of whatever stock you'd like to look up: http://www.wsrn.com/apps/earnings/company.xpl?s=jnpr&client_id=WSRN&f=EE.

A word on long-term growth rates. Analysts project a 3-5 year growth rate for Juniper of 50%. The company may well be able to deliver that, but few companies can sustain that level of growth for more than a few years. Technology changes rapidly, and few companies can keep up with the pace of innovation. Five years ago, networkers like Cisco , Cascade Communications, Ascend Communications and Xylan were projected to grow at long-term rates of 30-50%. Only Cisco was able to achieve that growth rate; the others faltered and were acquired.

The bottom line: you might want to begin putting on a position in Juniper at 50, but you'll have less risk at lower prices. And if you bought the stock anywhere near its low of 28.60, consider yourself lucky. An old saying is that bear markets are when stocks return to their rightful owners. With a tool like the PEG, you'll know when stocks begin to look like bargains.

A few other Net leaders and their PEGs. Openwave : PE of 152, two-year growth rate of 165%; PEG of .92. Count your lucky stars if you picked that one up at $13. Check Point Software : PE of 53, two-year growth rate of 45%; PEG of 1.17. Research in Motion : PE of 117 (February 2002 estimates), two-year growth rate of 140%; PEG of .84.

It's easy to see from just these few examples that leading stocks have become fully valued quickly. Investors may be pricing in an eventual economic recovery, but based on current PEG valuations, the market may have come too far too soon. Companies may grow faster than they are expected to, particularly if the coming rebound is a strong one, but so far the only hopeful signs have been of economic troughs, not of renewed healthy growth rates. Of course, it's always possible that we could see a return to high valuations, but after getting burned so recently, it's unlikely that investors will bid stocks up that high again so soon.

The PEG method obviously only works with companies that have positive earnings growth. It doesn't mean that companies whose earnings are declining or that are currently losing money have no value. Obviously, Amazon.com has intrinsic value regardless of whether or not it turns a profit this year. There are other ways to measure value, such as the price-to-sales ratio or return on equity, that we'll leave for another day.

But if you hold stocks for anything more than the short term, it's a good idea to make sure you're putting that money to work in a company that's likely to reward your investment. The PEG ratio is a simple tool for increasing the odds that that will happen.