If Darda is right, and our research seems to suggest he is, so-called “cheap stocks” may not be all that cheap. For proof, we can turn to some plain-old high school math. P/E ratios are calculated by taking the price of a stock (the numerator, or the “P”) and dividing it by earnings per share (the denominator, or the “E”). The higher the denominator, the lower the P/E ratio and, by implication, the cheaper a stock appears.

However, if higher denominators can make stocks appear “cheap,” then the opposite is true, too, and that suggests that stock prices may have a lot farther to fall – despite the fact that they’ve already tumbled 40% or more.

Just how much farther is anybody’s guess, but the outlook is not good.

For instance, according to Forbes writer James Clash, “more than a year into the market downturn that threatened Morgan Stanley’s (MS) survival, the 17 analysts covering the company cut their 2009 mean earnings estimates by 36% to $3.63 per share.” Given Darda’s observations, there may be another 35% to go, which would put total expected earnings cuts at 71%.

That sounds harsh, but it may not be out of line. Thompson IBES reports that the analyst community as a whole has cut 2009 earnings expectations by only 7.5% for the Standard & Poor’s 500 Index. If they are to be believed, that means that the analyst community expects the average S&P 500 company will have to grow earnings by 15% next year to $91, according to Clash.

We don’t know about you, but a time when recessionary flags are flying, we have a hard time buying that (pun absolutely intended).

That’s why – at the risk of igniting an e-mail firestorm – we point out that analysts are paid to have opinions and a huge body of evidence suggests that they’re strongly encouraged to make them bullish. Not only is this a cozy relationship for investment bankers in general, but it has historically helped Wall Street generate huge commissions from an anxious retail investing public that is desperately seeking good news. This bullish predisposition may be especially true at a time when investors are not inclined to buy – and with good reason.

Compounding the problem is the fact that many analysts focused on specific industries or companies tend to become quite myopic. Far too many don’t think outside the box and, as a result, are all too frequently surprised when macro-level events come crashing in on their little world and down on the companies they follow.

Investors who rely heavily on Wall Street analyst estimates are, in effect, driving down the highway using only their rearview mirror. The results are all too predictable.

Among the more infamous examples of these errant estimates was the group of analysts who, back in 2001, continued to recommend Enron Corp. stock all the way into bankruptcy and congressional hearings, based solely on their own “optimism.” Only when Enron shares were trading at less than $1 did the majority of analysts change their recommendations to a “hold.”

When it comes to Wall Street, the fox clearly does guard the financial hen house, so to speak.

In the interest of fairness, we should mention that there were “accounting irregularities” in the Enron case. But that really shouldn’t let anybody off the hook.

What’s happening now – and why we’re leery that things may not be as they seem – is that overall business and economic conditions are deteriorating faster than management is willing to publicly acknowledge (although we’re now watching these same management teams slash work forces and shutter plants at a rate we haven’t seen in years). And since management “guidance” (the sarcasm you detect is intended) is what drives and shapes Wall Street earnings estimates, this is why things are probably going to get worse before they get better. The earnings figures used in most P/E calculations haven’t yet been reduced.

As for the ratings agencies such as Standard & Poor’s, Moody’s Investors Corp. (MCO) and A.M. Best Co., these, too, are problematic when it comes to the earnings and the ratings that help drive them. Supposedly independent, it’s been common knowledge for years on Wall Street that firms wanting higher ratings need only coddle the agencies using a combination of fees and information. Of course the agencies will deny this but history suggests that’s like the pot calling the kettle black.  Historically, for example, Moody’s, S&P and Fitch Ratings Inc., have each earned huge amounts of income from fees being paid by the issuers whose credit they’re supposedly rating. That’s changing, of course, but as the credit crisis has highlighted so aptly, probably not fast enough.

So what does work?

P/E ratios are a start. But that longstanding indicator should be regarded as a relative measure of potential price and performance rather than the do-all stock-screen selector so many investors utilize them as.

When we analyze a company, we prefer to see expanding sales, advancing earnings and plenty of cold hard free cash flow. There’s an old saying on Wall Street that “nobody ever went broke on accrual accounting,” but clearly plenty of companies have figured out lately that they can go broke without cash. The best example may well be Detroit’s Big Three, which are grappling with this seemingly new reality even though we, as individuals, deal with it every day. As my six-year old son recently stated: “No cash … no dinner.”

One other excellent indicator is a so-called “PEG” ratio (the P/E divided by the growth rate) of less than 1.0. While it’s more commonly viewed using 12 month trailing earnings, we find it much more stable when viewed against a historical stream of data that’s a decade or more in length. Not only does this help screen out the volatility associated with much shorter time periods, but we find that companies with low PEG ratios calculated in this manner seem represent good value over the longer term.

Especially when compared to a deflated “E” – earnings.

Source: Stocks May Not be Cheap Enough, Yet – And Here’s Why

What’s tipping us off? The so-called Price/Earnings-to- Growth ratio, better known to investors as the “PEG” ratio.

Let me explain …

One of the most popular stock valuations is the Price/Earnings (P/E) ratio. If you take that calculation one step further and include a stock’s expected growth rate you hit on the P/E-to-growth ratio, or PEG ratio.

Analysts have been using PEG ratios for years, now, to pick undervalued stocks, but now you also can use that same ratio to determine which countries are trading at good value.

A recent Bespoke Investment Group report used the popular PEG ratio to identify which country’s stocks are currently undervalued.

“Late last year, we began performing this analysis on countries to get a better comparison of the valuations of both developed and emerging markets,” the B.I.G. Tips report read. “To do this, we divide the country’s [gross domestic product] growth estimate into the estimated P/E ratio of its major stock market index.”

Like an individual security’s PEG ratio, the lower the ratio, the more undervalued the stock.

The top-three spots on that list go to Russia (1.37), China (1.91) and India (2.06). Brazil clocks in at sixth with 2.80. Money Morning readers may recognize them as member of the “BRIC” nations – a term coined by Goldman Sachs Group Inc. (GS) in 2003 identifying rapidly growing emerging economies (Brazil, Russia, India, China). [For a complete listing of the PEG ratios of the respective countries, please see the chart below.]

Rounding out the top six are Malaysia (2.37) and South Korea (2.66), the latter of which is another investing favorite of both Money Morning and Warren Buffett, chairman of Berkshire Hathaway Inc. (BRK.A, BRK.B).

The United States, on the other hand, comes in near the bottom with an estimated PEG ratio for 2008 of 11.39.

When using the calculations to make investment picks, it’s important to remember that both the P/E ratio and the 2008 GDP growth are only estimates. Still, it’s easy to see how fast-growing economies have the leg up on more mature markets such as Japan and the United States.

How to Play the PEG for Profits

One of the easiest ways for U.S. investors to cash in on a foreign country’s expected stock market growth is with an American-listed exchange-traded fund (ETF) or exchange-traded note (ETN) that mirrors a foreign stock market index.

For the BRICs, you could try the iShares MSCI Brazil Index (EWZ), the Market Vector Russia ETF Trust (RSX), the Barclays IPath India Index ETN (INP), or the iShares FTSE/Xinhua China 25 Index (FXI).

If you prefer to stick to individual securities:

Russia: OAO Gazprom (OTC: OGZPY), the state-owned natural gas monopoly with ambitions to control Western Europe’s gas supplies.

Lukoil (OTC: LUKOY), the other obvious Russian heavyweight, is the largest state-controlled oil company.

China: A terrific way to play China is with the Region Opportunity Fund (USCOX), a mutual fund run by San Antonio-based U.S. Global Investors Inc. (GROW). Indeed, U.S. Global, itself, is a pretty good play on international growth. It manages some of the best emerging-market funds, and natural-resources funds, in the business. As global growth fuels global investments – and it will – U.S. global will see more money pour into its funds, boosting the management fees it collects, as well as its profits and stock price.

India: One of India’s titans is Tata Motors Ltd. (TTM), which recently sealed both ends of the consumer automotive spectrum with its forthcoming $2,500 Nano and its recent $2.3 billion acquisition of the Jaguar and Land Rover brands.

Another is option could be the pharmaceutical company Dr. Reddy’s Laboratories Ltd. (RDY). As many U.S. pharmaceutical patents expire in the next five years, this major generic-drugs manufacturer can expect to benefit.

South Korea: Back in October 2007, Buffett took a 4% stake in this country’s Number One steelmaker, POSCO Ltd. (PKX). Studies have shown that following Buffett’s investment moves, even months after the fact can be the pathway to profits.

Brazil: Companhia Vale do Rio Doce, now referred to only as Vale (RIO), is an iron-ore company with ancillary operations in gold, nickel, copper and other metals. It’s one of the true global blue chips, with a market capitalization of almost $200 billion.

Another Brazilian firm worth a look is Petrobras (PBR). It’s one of the few emerging market oil companies with access to modern technology – and the willingness to work with the oil majors.

Source: Popular Stock Indicator Tells Investors to Hit the BRICs