Lesson 4 of 7
Lynch: six categories and the PEG
Sort a company into Lynch's six categories, test his rule that a fair P/E equals the growth rate, and see where it breaks.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Lynch sorted every company into one of six categories first, because a slow grower and a fast grower are judged by different questions.
- His rule of thumb: a fairly priced company's P/E equals its growth rate in earnings, with half that rate attractive and twice it unattractive.
- The rule compares a price with a growth rate and says nothing about how that growth is earned, so two very different businesses can share the same score.
Peter Lynch's One Up on Wall Street sorts companies into six categories before valuing them, because a fast grower and a cyclical earn their returns in different ways and fail in different ways too. Only after sorting does he turn to the P/E ratio, checked against the growth rate it should roughly equal.
The same rule, three companies
- P/E 20, growth 20%1.0
- P/E 30, growth 10%3.0
- P/E 12, growth 15%0.8
Fairly priced, Lynch's rule: 1.0
Six categories, six questions
Lynch sorted companies into six categories before valuing any of them, because each one is judged by a different question.
| Category | What it is | The question Lynch asks |
|---|---|---|
| Slow grower | A large, aging company growing near the pace of the economy, usually paying a generous dividend | Is the dividend worth more than a faster grower's price |
| Stalwart | A multibillion-dollar company growing 10 to 12 percent a year | Has the price already run too far for a further 30 to 50 percent gain |
| Fast grower | A small, aggressive company growing 20 to 25 percent a year | How much room is left before the growth runs out |
| Cyclical | A company whose sales and profits rise and fall with the business cycle | Where does it sit in its own cycle right now |
| Asset play | A company sitting on a valuable asset the market has overlooked | What is that asset actually worth |
| Turnaround | A battered or bankrupt company that could recover | Will it survive, and what would recovery look like |
Applying one valuation rule across all six, without first asking which one a company is, is the mistake the categories exist to prevent.
The rule: P/E against the growth rate
PEG equals P/E ratio divided by Earnings growth rate, as a percentage.
Example20 ÷ 20 = 1.0
Lynch's own statement of it: a fairly priced company's P/E should roughly equal its growth rate in earnings. He treats half the growth rate as very attractive and twice the growth rate as very unattractive.
The three bars above show the same test on three companies. The 30x company growing only 10 percent a year scores 3.0, well past his negative threshold. The 12x company growing 15 percent scores 0.8, on the attractive side of fair. The growth rate in the denominator does most of the work: the same P/E of 20 would score 2.0 against 10 percent growth and 0.67 against 30 percent.
Lynch's dividend-adjusted version equals Growth rate + dividend yield divided by P/E.
Example(12 + 3) ÷ 10 = 1.5
Here higher is better: under 1 is poor, 1.5 is okay, and 2 or better is what he looked for. This version credits a slow grower's dividend, which the plain PEG above leaves out entirely.
Where the same score hides two different businesses
What the rule leaves out
A growth rate is a forecast, and the PEG treats it as though it were filed fact. It also assumes the growth is worth having: growth funded at a return below the cost of the capital it consumes destroys value even while increasing earnings, and a PEG of exactly 1.0 looks identical whichever case you are in. The rule is a quick filter, not a finished valuation, and Lynch's own two-minute drill, sorting a company into its category and then stating in a couple of minutes why it should do well, is the further check this page does not replace.
Check yourself
A company has a P/E of 12 and earnings growth of 15 percent. What is its PEG?
- 1.25
- 0.8
- 3.0
Show the answer
Answer: B.
12 divided by 15 is 0.8, on the attractive side of Lynch's fair value of 1.0.Under Lynch's rule, a P/E at twice the growth rate is described how?
- Fairly priced
- Very attractive
- Very negative
Show the answer
Answer: C.
Lynch states a P/E twice the growth rate as very negative, and half the growth rate as very positive.Two companies both have a PEG of 1.0. What can the PEG alone not tell you about them?
- Their P/E ratios
- Their growth rates
- Whether the growth is earned above or below the cost of the capital funding it
Show the answer
Answer: C.
The PEG compares price with a growth rate only. Whether that growth creates value depends on the return earned on the capital behind it, which the ratio does not measure.Sources
- Lynch with Rothchild, One Up on Wall Street, 1989 (millennium edition 2000), chapter 7: the six categories.
- Lynch with Rothchild, One Up on Wall Street, 1989 (millennium edition 2000), chapter 11: the two-minute drill.
- Lynch with Rothchild, One Up on Wall Street, 1989 (millennium edition 2000), chapter 13: a fairly priced company's P/E equals its growth rate.
What this leaves out
- The three companies in the bar chart and the two in the worked example are round invented inputs, not any filed company's figures.
- A growth rate is a forecast. The rule treats it as given and says nothing about how likely it is to hold.
- The PEG does not adjust for debt, and a company can raise its growth rate with borrowed capital in a way the ratio cannot see.
- Nothing here is advice about any security.