Peter Lynch's Secret Formula for Valuing a Stock's Growth
The P/E Ratio, PEG Ratio, and Dividend-Adjusted PEG Ratio
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. It was Peter Lynch who helped introduce me to the concept of stocks ultimately being proportional ownership stakes in operating businesses; that the stock market is effectively an auction and what really counts is the underlying performance of the enterprise, which eventually exerts itself if you hold for long enough and pay a reasonable enough price relative to net present value and, in some rarer cases, assets on the balance sheet.
Through Lynch, I came to be introduced to the writings of people like Benjamin Graham, Philip Fisher, and others who had an enormously beneficial influence on my capital allocation framework.
One of Peter Lynch's books is called One Up on Wall Street. If you forced me to identify the one text that was probably more important to my development as an investor than all of the other countless writings I've consumed, it'd win the crown. Even today, I have three copies in my personal library, one of which is among my most cherished possessions. Had I not read it as a child back in the early to mid-1990s, it is highly doubtful my career trajectory would have ended up like it did; that I would have been writing as the Investing for Beginners Expert since 2001 or in the midst of launching a global asset management business for affluent and high net worth individuals, families, and institutions.
My particular mental wiring already predisposed me to fundamental investing but Peter Lynch made me a lifetime convert.
Among the lessons in One Up on Wall Street - and there are many investing tips, including one of my favorite portfolio questions you should ask yourself at the end of each year - Lynch gave a simple, straight-forward explanation as to his preferred metric for doing a quick and dirty valuation of a firm's investment prospect.
Before I give you my take on it, and offer some expansion for new investors who need to be walked through the specifics, let me give you the direct quote:
"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 offer a different approach to the same basic concept:
"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."
The P/E Ratio vs. The PEG Ratio vs. The Dividend Adjusted PEG Ratio
What does all of this mean? In effect, Peter Lynch is introducing the reader to two concepts, the PEG ratio and the Dividend-Adjusted PEG ratio, which are more advanced, more informative versions of the price-to-earnings ratio. I've written specific articles on all three, with explanations to walk you through the math, but let me summarize them here to give you a brief overview of help clarify the concepts.
- The Price-To-Earnings Ratio - As you learned in my article Using the Price-to-Earnings Ratio As a Quick Way to Value Stock, the p/e ratio, as it is often known, involves taking the current stock price and dividing by the basic or diluted earnings per share. The p/e ratio effectively tells you, 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 the dividends. One of my favorite metrics is to invert the p/e ratio and use something known as the earnings yield, which you can then normalize (look at over an entire business cycle and make some accounting adjustments) to compare to Treasury bond yields as a basic gauge of whether stocks are overvalued, fairly valued, or undervalued.
- The PEG Ratio - As you learned in my article Using the PEG Ratio to Find Hidden Stock Gems, the PEG ratio attempts 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% but the other at 9%, you can identify the latter as a demonstrably superior bargain that will most likely make you more money.
- The Dividend-Adjusted PEG Ratio - Going even further, as you learned in my article The Dividend Adjusted PEG Ratio Can Help You Find Undervalued Blue Chip Stocks, the dividend-adjusted PEG ratio is a special metric that takes the PEG ratio and attempts to make up for a shortcoming it has by factoring in dividends, which make up a big part of the total return of most stocks, into the picture. This is particularly important when investing in blue chip stocks as well as certain specialty enterprises such as the oil majors. 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%, it may look expensive. If it is distributing a sustainable 8% dividend, it's more than a fair deal.
As you get more advanced, and learn the intricacies of corporate finance, accounting, and business; when you learn to read a balance sheet and analyze an income statement, you'll most likely substitute a different metric based upon free cash flow for the earnings variable in these formulas. Personally, I prefer something known as owner earnings. It actually measures the amount of money a private owner could extract from a business without hurting the company's competitive position.