While the PE Ratio may be the classic equity investors valuation ratio, with reams of investment literature showing that buying low PE Ratio stocks is an extremely profitable strategy, not everyone wants to spend their stock picking days digging solely amongst the basket cases and recovery plays that low PE investing often uncovers.

Many investors want to buy growing companies, with great stories and prospects, but these stocks often come priced at a significant premium to the market. How do you tell if a growth stock is still a bargain as the valuation and PE rises?

Lynch Mob

Peter Lynch, the most famous of all Fidelity’s fund managers, popularised the PEG ratio as a solution to this in his famous investment book ‘One up on Wall Street’. Taking Walmart as an example he showed that if you can pick up stocks trading at PE Ratios of less than their growth rate you may well have found yourself a bargain. Lynch used the PEG in his range of strategies to rack up an peerless record while managing the Magellan fund from 1977 through 1990 acing the market with a 29% annualised return. Ever since, the PEG ratio has been a standard weapon in the arsenal of most fund managers and smart stock pickers, but while it does have its champions it also has many critics, making it wise for investors to delve a deeper understanding of its limitations.

PEG and PEGY Defined

Traditionally The PEG is calculated by taking the historic or trailing PE Ratio and dividing it by the forecast EPS Growth rate. It can be thought of as a ‘growth adjusted’ PE Ratio, standardising the PE Ratio to allow quick comparison between cheap and expensive companies relative to their growth rates. For example a glamorous growth company on a PE of 20 growing at 30% per year would be on a PEG of 0.66, whereas a company on a PE of 10 growing at 5% per year would be on a PEG of 2 . The theory of PEG investing is that you should aim to buy companies on low PEGs of less than 1 so that you get more growth for your buck.

For Mature businesses the traditional PEG ratio often becomes rather meaningless as these companies tend to have fewer growth opportunities.  But Peter Lynch found away to adjust the PEG Ratio to factor in the more sizeable dividend yields that these companies…

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