One of the quickest ways to tell if a company is over or undervalued is to look at its price-to-earnings ratio (P/E) and compare it with the overall P/E of the market—for example, the S&P 500 Index or the Dow Jones Industrial Average. If the P/E of the company is greater than that of the market, the stock is relatively more expensive. But what if the company is growing much faster than the average company? Shouldn’t it then have a higher P/E? What should that P/E be? In his book One Up on Wall Street, Peter Lynch (2000) wrote, “The p/e ratio of any company that’s fairly priced will equal its growth rate” (p. 199). Let’s take a look at that and see what he meant.

We discussed the P/E and why it is a good measure of the relative valuation of two companies in a previous post here. One of the major drawbacks of this valuation measure, however, is the static nature of the analysis it provides. If you’re thinking that sounds a bit wonky, you’re right, it does. OK, it sounds really wonky! Geez.

What I mean by “static nature” is that the P/E really just looks at valuation at one point in time, like a snapshot of the two companies at that moment. One of the things that comparing the P/Es of two companies fails to take into account is the respective growth rates of each of the companies—in other words, how much each company will earn next year compared with what it earned this year.

What we are really talking about here is something that is commonly referred to as the “PEG ratio,” or the ratio of the P/E to growth. If we think about what Lynch was saying in terms of a formula, we could say

Fair P/E = Growth rate.

Dividing both sides by the growth rate yields

Fair P/E/Growth rate = 1.

This formula represents the PEG ratio. So, a PEG ratio greater than 1 means the stock is relatively expensive, whereas a PEG ratio lower than 1 means a stock is below its “fair value.”

I can hear the purists now: “That’s not right! You are comparing percentages with multiples!” True. But as always, these measures are to be looked at and thought of more as guidelines than hard and fast “laws of finance.”

This process will probably be easier if we look at an example. Let’s compare two different companies that are both going to earn a million dollars this year. Let’s call them Growth Co. and Mature Co.

The difference between the two companies is that Growth Co. is going to grow by 50% next year and Mature Co. is going to grow only 5%, or about as much as the average company in the economy. To make the math easy, let’s say that the P/E for the “average company” in the economy is 10 times what that company will earn next year.

So, the question becomes, What would be a fair price for each of these companies with the additional information we now have?

It should be fairly easy to understand that Growth Co. will probably be worth more than Mature Co. Let’s try to figure out how much more.

Mature Co. is going to earn $1,050,000 next year based on its 5% growth rate. Therefore, based on the P/E for the average company, Mature Co. should be valued at $10,500,000. That’s pretty straightforward. So far, so good.

But what about Growth Co.? What would be a fair value for that company? Remember what Peter Lynch said. The P/E for Growth Co. should equal its growth rate, which means that a fair P/E for Growth Co. is 50 times next year’s earnings.

Growth Co. is going to earn $1,500,000 next year based on its 50% growth rate. So, based on Peter Lynch’s fair P/E of 50 times, Growth Co. should be valued at $75,000,000.

Hang on. That’s a lot more than the valuation for Mature Co. I mean, that’s about seven times more! Isn’t that a lot? Well, it may not seem so extreme when we consider that the growth rate for Growth Co. is actually 10 times more than the growth rate for Mature Co.

There are some drawbacks to using the PEG ratio. First of all, Growth Co. is not going to grow at a 50% growth rate forever. The PEG ratio doesn’t suggest how long the 50% growth rate will persist or what the growth rate is likely to be 5 or 10 years from now. Also, when compared with more detailed discounted cash flow analyses, the PEG ratio tends to undervalue companies with extremely high, almost exponential growth rates—such as those above 100%. So, like most other valuation metrics in finance, the PEG ratio is not a “be all and end all” measure, but it does provide a quick and dirty yardstick for identifying potentially under- or overvalued securities.

Does it make sense to value companies this way? What do you think? Tweet me @SconsetCapital or ask them in the comments below.

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