We all are aware of Peter Lynch, the former manager of Fidelity Funds, and has been a prominent fund managers of his time, and his philosophies about stock investments are truly valid even now. In his books, Peter Lynch regularly looked into information regarding growth-oriented companies that capitalized on current market trends. When traditional criteria such as the price-to-earnings ratio were used to examine these equities, they often seemed to have high values. But in hindsight, they appeared to be reasonably priced given their potential for development. Any firm that is fairly priced will have a PE ratio equal to its growth rate. Lynch used the PEG ratio (Price-Earnings-Growth) to improve his research of growth-oriented firms. This ratio is created by dividing the company’s price-to-earnings ratio by its growth rate. (We need to carefully note here that the company’ growth rate in this formula is not the sales growth rate, but the earnings growth rate.)
This measure was one of Lynch’s favourite strategies for stock evaluation. Here’s how it works: Let’s compare two firms (Company ‘A’ and Company ‘B’) with a price-to-earnings ratio of 20 each. On first glance, they may appear identical, but let’s look at their growth rates. Assume Company A’s earnings are increasing at a rapid pace of 30%, whereas Company B’s earnings are increasing more slowly at 10%. In this case, Company A’s PEG (price-to-earnings-to-growth rate) is 0.83 (20 divided by 30 = 0.67), but Company B’s PEG is 2.00 (20 divided by 10 equals 2.00).
A lower PEG ratio suggests a more enticing valuation based on a company’s growth potential. According to Lynch’s investing philosophy, a PEG ratio of 1.0 or lower was considered very favorable. Lynch went one step further when examining firms that paid dividends and were classified as having slow growth. He understood that dividend yields had a major impact on the total return of slower-growing companies. In such cases, Lynch modified the PEG ratio by including the dividend yield into the earnings growth rate in the denominator of the PEG formula, yielding a yield-adjusted PEG ratio.
