Peter Lynch's Secret Formula for Valuing a Stock's Growth

The P/E Ratio, PEG Ratio, and Dividend-Adjusted PEG Ratio

Peter Lynch was fond of using modified forms of the p/e ratio known as the PEG ratio and dividend-adjusted PEG ratio.
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Arguably the greatest mutual fund manager in history, Peter Lynch's astounding record at the helm of the flagship Fidelity fund before retiring guaranteed him a permanent spot in the money management hall of fame.

Stocks as Proportional Ownership

Peter Lynch has discussed the concept of stocks being essentially proportional ownership stakes in operating businesses, and that the stock market is effectively an auction. He stressed the importance of the underlying business enterprise strength, which he believed eventually exerts itself in the company's stock price performance when holding the stock for the long term, and paying a reasonable price relative to the company's market value.

Interpreting a Stock's Price-to-Earnings Ratio

Peter Lynch penned many popular investing books, including One Up on Wall Street. Among the lessons offered in One Up on Wall Street, Lynch gave a simple, straight-forward explanation regarding one of his preferred metrics for doing a high-level valuation of a firm's investment prospect. He calculated a given stock's price-to-earnings ratio, or P/E ratio, and interpreted the results as follows, directly quoted from his book:

"The P/E ratio of any company that's fairly priced will equal its growth rate ... If the P/E of Coca-Cola is 15, you'd expect the company to be growing at about 15 percent a year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year...and a P/E ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a P/E ratio of 12 is an unattractive prospect and headed for a comedown...In general, a P/E ratio that's half the growth rate is very positive, and one that's twice the growth rate is very negative."

Later, Lynch goes on to layer in a few tweaks to the standard P/E ratio formula to offer a more in-depth level of company performance analysis:

"A slightly more complicated formula enables us to compare growth rates to earnings, while also taking the dividends into account. Find the long-term growth rate (say, Company X's is 12 percent), add the dividend yield (Company X pays 3 percent), and divide by the P/E ratio (Company X's is 10). 12 plus 3 divided by 10 is 1.5...Less than a 1 is poor, and a 1.5 is okay, but what you're really looking for is a 2 or better. A company with a 15 percent growth rate, a 3 percent dividend, and a P/E of 6 would have a fabulous 3."

What does all of this mean? In effect, Peter Lynch is introducing the reader to two stock-analysis concepts he developed, the PEG ratio and the Dividend-Adjusted PEG ratio, which are more advanced, more informative versions of the price-to-earnings ratio.

Introduction to the Price-to-Earnings Ratio

The price-to-earnings, or P/E ratio, involves taking a company's current stock price and dividing it by the basic or diluted earnings per share. The resulting number effectively tells you how much you can expect to put into a company to get back $1 of its earnings. For example, if a company's P/E ratio is 20, you'd interpret this as investors saying they'll pay $20 per share for $1 of the company's earnings. Stated differently, a stock trading at a P/E ratio of 20 is trading at 20x its annual earnings.

Some call the P/E ratio the price multiple or the earnings multiple.

Another way to look at the P/E ratio is that it tells you, given your current or desired investment, if a company had no growth and earnings stayed exactly the same, how many years it would take to recapture your current investment from the underlying profits alone, ignoring any taxes you'd have to pay on dividends received. The P/E ratio can be calculated using historical earnings, known as a trailing P/E, or forecasted earnings for a projected P/E.

Lynch's PEG Ratio

Peter Lynch developed the PEG ratio as an attempt to solve a shortcoming of the P/E ratio by factoring in the projected growth rate of future earnings. That way, if two companies are trading at 15x earnings, and one of them is growing at 3 percent but the other at 9 percent, you can identify the latter as a better bargain with a higher probability of making you a higher return. The formula for PEG is:

PEG Ratio = P/E Ratio / company's earnings growth rate

To interpret the ratio, a result of 1 or lower says the stock's either at par or undervalued based on its growth rate. If the ratio results in a number above 1, conventional wisdom says the stock is overvalued relative to its growth rate. Many investors feel the PEG ratio gives a more complete picture of a company's value than a P/E ratio.

The Dividend-Adjusted PEG Ratio

Taking the analysis a step further, the dividend-adjusted PEG ratio is a special metric that takes the PEG ratio and attempts to improve upon it by factoring in dividends, which make up a substantial part of the total return of many stocks. This is particularly important when investing in blue chip stocks as well as certain specialty enterprises such as the major oilcompany stocks. Reinvested dividends, especially during stock market crashes, can create what one respected academic referred to as a "return accelerator," drastically shortening the time it takes to recover losses.

If you buy a stock at 19x earnings that is growing at only 6 percent, it may look expensive. However, if it's distributing a sustainable 8 percent dividend, that's clearly a much better deal. Calculate this metric as follows:

Dividend-adjusted PEG ratio = P/E ratio / (earnings growth + dividend yield)

For example, say you invested in company XYZ, and it's currently trading at $100 per share. It's earnings were $8.99 per share over the past year. First, calculate its P/E ratio:

XYZ P/E ratio = $100 / $8.99 = 11.1

Next, say you find through your research that XYZ's projected to grow earnings by 9 percent over the next three years. Now calculate the PEG ratio:

XYZ PEG ratio = 11.1 / 9 = 1.23

However, this doesn't factor in XYZ's dividend yield of 2.3 percent. Plugging this information into the dividend-adjusted PEG ratio results in the following:

XYZ dividend-adjusted PEG ratio = 11.1 / (9 + 2.3) = .98

When comparing the results, you see that, after adjusting for dividends, XYZ's stock is cheaper than you might think when relying only upon the PEG ratio result.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.