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.
••• Peter Lynch was fond of using modified forms of the p/e ratio known as the PEG ratio and dividend-adjusted PEG ratio. These allowed him to factor in a stock's growth and dividend into the price-to-earnings calculation and better understand how much he was paying for the business. Tetra Images / Getty Images

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.

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.