Peter Lynch's Formulas for Valuing a Stock's Growth

Peter Lynch may have been the greatest mutual fund manager in history. His astounding 13-year record at the helm of the flagship Fidelity Magellan Fund guaranteed him a permanent spot in the money management hall of fame. Lynch retired in 1990 at age 46. These are his principles for the valuation of stocks.

Stocks as Proportional Ownership

Lynch espoused the concept of stocks being a proportional ownership in operating businesses, with the stock market effectively an auction. He stressed the importance of looking at the underlying business enterprise strength, which he believed eventually shows up in the company's long-term stock price performance. Also, pay a reasonable price relative to the company's market value.

Price-to-Earnings Ratio

In his book One Up on Wall Street, Lynch gives a simple, straightforward explanation about one of his preferred metrics for determining a high-level valuation of a firm's investment prospect. He calculates a given stock's price-to-earnings (P/E) ratio and interprets the results as follows:

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.

For context, the P/E ratio involves taking a company's current stock price and dividing it by the basic or diluted earnings per share. The resulting ratio effectively tells you how much you can expect to put into a company to get back $1 of its earnings. A stock trading at a P/E ratio of 20, for instance, is trading at 20 times its annual earnings. Some call the P/E ratio the price multiple or the earnings multiple.

Later in his book, Lynch layers in a few variations to the standard P/E ratio formula to offer a more in-depth level of company performance analysis. In effect, Lynch is introducing the reader to two stock-analysis concepts he developed: the price-to-earnings-to-growth (PEG) ratio and the dividend-adjusted PEG ratio, which are more informative versions of the P/E ratio.

Price-to-Earnings-to-Growth Ratio

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

The formula is:

• PEG ratio = P/E ratio / company's earnings growth rate

To interpret the ratio, a result of 1 or lower says that the stock is either at par or undervalued, based on its growth rate. If the ratio results in a number above 1, conventional wisdom says that the stock is overvalued relative to its growth rate.

Dividend-Adjusted PEG Ratio

Lynch took his analysis a step further with the dividend-adjusted PEG ratio. This 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 in certain specialty enterprises such as the major oil company 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 19 times earnings that is growing at only 6%, it may look expensive. However, if it is distributing a sustainable 8% dividend, that's clearly a much better deal. The formula is:

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

Example: Calculating the Ratios

As an example, suppose you invested in company XYZ, and that it is currently trading at $100 per share. Its 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, suppose you find through your research that XYZ is projected to grow earnings by 9% over the next three years. Now calculate the PEG ratio:

• XYZ PEG ratio = 11.1 / 9 = 1.23

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

• XYZ dividend-adjusted PEG ratio = 11.1 / (9 + 2.3) = 0.98

When comparing the results, you should see that, after adjusting for dividends, XYZ's stock is cheaper than you might think.

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