Peter Lynch's PEG ratio

Peter Lynch was the fund manager of the Fidelity Magellan fund, a large U.S. based equity fund which was the No. 1 ranked U.S. fund in its category for a number of years. During his stewardship of the fund, Lynch delivered an astonishing CAGR of 29% to his investors.

Peter Lynch is not, in the strict sense of the term, a value investor. He is probably best described as a GARP (Growth at a Reasonable Price) investor. We had discussed GARP earlier here. One of Peter Lynch's most famous tools is the PEG (Price-Earnings-Growth) ratio, which is a modification of the P/E ratio. The P/E ratio measures the company's price in relation to its earnings, and high P/E ratios are a clear no-go-area for v investors.

However, Peter Lynch believes that high P/E ratios are justified provided the company is growing its earnings at a pace fast enough to justify such high valuations. The PEG ratio is calculated by dividing the P/E ratio of the stock by its growth. A PEG ratio < 1 means that the P/E ratio, even if it is high by normal standards, is still not in over-valued territory. Hence, the stock might still be worth evaluating.

The risk here is that it is very difficult to exactly evaluate a company's potential growth. Even a company which is in a high-growth industry might be hit by unexpected hiccups, such as the departure of a respected manager, failures in R&D, etc.

Hence, my view is that while PEG is an attractive intellectual model, it is a highly subjective framework, in that it requires an investor to be able to evaluate the prospective growth of companies with a reasonable degree of certainty. As many investors found out to their dismay in 2008, even the best analysts are often unable to predict earnings accurately. Alternatively, investors/ analysts may predict earnings well, but the overall economic environment might deteriorate, and all such analyses might need to be invalidated.

With this in mind, value investors are advised to stick to investing in companies with a sufficient margin of safety, and to enter into PEG situations, only if they are very very confident of what they are entering into. 2 words come to mind: Buyer Beware!