PEG Ratio - Favourite Stock Picking ratio of Peter Lynch

Ace American investor Peter Lynch Managed the Magellan fund from 1977 to 1990 and consistently delivered 2x of S&P 500 index returns. To be precise, Peter Lynch generated 29.2% annual returns. Further, in 1989, he wrote the best-selling book "One Up on Wall Street," which we would also recommend for you all to read.

In this book, he has shared how his favourite metric for stock analysis is none other than PEG ratio i.e. price earnings to growth ratio. Thus, in today’s article we will discuss the importance of PEG ratio and why it is so important.

Before we understand what PEG ratio is, let us first discuss two investment approaches i.e. value investing & growth investing.

Let's begin with value investing. In this approach, investors look for stocks that are trading at a price lower than their intrinsic value. To do so, some important metrics are used, such as the price-to-earnings (P/E) ratio. Let's understand how the P/E ratio is calculated.

The P/E ratio is nothing but the company's share price divided by its earnings per share. Instead of using the price of a single share or earnings per share, you can also divide the company's market cap by its overall net profit and get the same result. In short, the P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. A high P/E ratio could mean that a stock's price is high relative to its earnings and possibly overvalued. Conversely, a low P/E ratio might indicate that the current stock price is low relative to earnings.

Let's take an example:

Let us look at Company A. It has a market cap of 1000 crores and net profit of 100 crores. So it P/E ratio will be 1000 divided by 100, which is 10. Generally, low P/E ratio is considered favourable for investment. Value investors tend to search for and prefer to invest in undervalued stocks. This is due to the fact that undervalued stocks typically have good fundamentals and enjoy a higher chance of share price appreciation in the future. In growth investing, investors favour fast-growing companies even if they look expensive on a valuation basis. Let's consider Company B. Like Company A, it also has a profit of rupees 100 crores, but there's one twist: 5 years ago, the profit of Company A was rupees 100 crores, but at the same time, the profit of company B was 40 crores rupees, which has now grown to be around 100 crores. Chances are the company B has a higher valuation, even if we assume it has a market cap of rupees 2500 crores or a P/E ratio of 25. Investors may prefer Company B because of its fast-growing profits.

So now, if you are getting one signal from the value investing approach and another signal from the growth investing approach, what should you do? There is a ratio through which one can adjust the company's value for its growth rate and get a better picture than looking at value or growth alone. This is the PEG ratio.

Now let us understand the same with the help of an example: As we saw earlier, the P/E ratio of company A was 10 and its historical profit growth is 5%. Also, in the past 5 years, its profit only grew from rupees 80 crores to rupees 100 crores. In applying the PEG ratio, we will divide its P/E ratio by its growth rate, meaning, 10 divided by 5, and the answer is 2. Whereas, when we consider company B, its P/E ratio is 25 but it growth rate is around 25%. Now, when we apply the PEG ratio to company B it comes to 1. In simpler terms, the PEG ratio tells you how the company's valuation looks like after you adjust it for growth rate. The lower the PEG ratio, the better it is. After all, Company A looks attractive on a standalone P/E ratio basis of only 10, but it is also growing at only five percent, whereas Company B demands earnings multiple of 25, but it is also growing at 25 percent.

Remember, top investors such as Warren Buffett don't blindly chase companies only if they look cheap on a valuation basis. In fact, they prefer to buy strong or fast-growing companies, even if it means you don't get a bargain deal. As Buffett says, "It is better to buy a wonderful company at a fair price rather than a fair company at a wonderful price."