One Ratio to Invest Like Peter Lynch
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Proponents of value and growth investing have been discussing the advantages of their preferred strategies for decades: should you buy cheap stocks or pick high growth companies? The discussion is certainly very interesting from an intellectual point of view but, fortunately for investors, there is no need to choose one camp and stay away from the other when looking for the most attractive investment ideas.
The value vs. growth discussion can be worked out when growth rates are incorporated into valuation ratios to get a more complete picture about the merits of a particular investment. It was Peter Lynch himself, one of the greatest investment luminaries of all times, who popularized the PEG ratio as a simple and intuitive tool to include growth perspectives into valuation in order to make better investment decisions.
The PEG ratio simply divides P/E by expected growth rates to put valuation and growth into context. A company trading at a P/E ratio of 15 and with an expected growth rate of 15%, for example, would have a PEG of 1. If the P/E was 15 but the expected growth rate was 20%, the PEG would be 0.75 (15/20). This way, we have a mathematical tool to evaluate how cheap or expensive a stock is, including both value and growth perspectives.
Lynch wrote in his excellent book One Up on Wall Street that "The P/E ratio of any company that's fairly priced will equal its growth rate", i.e., a fairly valued company will have its PEG equal to 1. Like every valuation tool, the PEG ratio needs to be analyzed in conjunction with business and fundamental considerations for each company, but an attractive PEG ratio is a nice starting point when looking for companies which are attractively priced in relationship to their growth potential.
According to this concept, for example, Apple (NASDAQ: AAPL) is still cheap in spite of the tremendous run up it has had over the last years. The Cupertino giant carries a P/E below 16.5, which combined with an average expected growth rate of 21.7% by Wall Street analysts over the next five years yields a PEG of 0.76, well below Lynch´s proposed level of 1.
Some analysts have expressed concerns with the growth rate of 25% the iPhone 5 showed in its first week in the market, with 5 million units versus 4 million units for the previous model – iPhone 4S - in its initial week. But according to Lynch´s recommendation to buy stocks with a PEG below 1, Apple is still attractively valued in a 25% annual growth scenario.
Besides, one week is by no means a long enough period to evaluate the true potential of a product, since aspects like production levels, inventory and logistics can have an important impact on sales figures on such short timeframes.Customers are still eagerly depleting inventories for the iPhone 5, so there is a good chance that the new Apple smartphone will do better than what the first figures may imply once production and distribution catch up with demand.
In any case, Apple should easily surpass a growth rate of 16.5% over the following years, meaning that even if earnings suffer a material slowdown from current growth levels, the stock still has plenty of potential before reaching a PEG ratio of 1.
Chinese search engine Baidu.com (NASDAQ: BIDU) is also looking attractive on a PEG basis, trading at a 0.68 ratio. The company is benefiting from Google´s (NASDAQ: GOOG) retreat from the Asian country due to disputes with government authorities over censorship issues in 2010, which leaves Baidu as the indisputable leader with an 80% market share in such an lucrative market.
In more good news for the company, Google announced last week that it will be closing its Chinese music search business, opening the door for better opportunities in that business over the following years for Baidu. Legal downloads are not easy to enforce due to piracy problems in China, but the fact that Google keeps parting away from the country bodes well for Baidu in the middle term when it comes to competitive position in different business areas.
Investors need to be careful when applying this ratio to cyclical companies like Toyota (NYSE: TM) and Ford (NYSE: F), both of which look very attractive at PEG ratios of 0.4 and 0.3 respectively. The auto business is tremendously hard, with high capital requirements, elevated fixed costs and cyclical revenues in a very competitive industry.
Both Toyota and Ford own valuable brands and have launched some well-considered models lately, Ford in particular has made many notorious improvements over the last years from an operational and financial point of view. But if the economy doesn´t help, sales and growth could be well below estimates in the middle term for these two automakers. These companies offer a juicy potential for gains if things go as expected, but they are particularly exposed to the economic cycle too.
No investment philosophy can be summed up to a mathematical ratio, and no calculation avoids the need for deep company specific research. But looking for low PEG stocks can be an excellent starting point to find attractive investment opportunities for further research, at least according to Peter Lynch.
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acardenal has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Baidu, Ford, and Google. Motley Fool newsletter services recommend Apple, Baidu, Ford, and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.