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Imagine you are only allowed to buy one share . Company A with a P/E ratio of 15 or Company B with a P/E ratio of 25. Most people instinctively say Company A. Peter Lynch says, what nonsense, because the crucial key figure [ahem] is missing. Yes, hello. I'm Arnold, the finance teacher, and today we're talking about money again.
Today, we will take a closer look at the topic of stock valuation, building on our last P/E ratio deep dive, by learning about the PEG ratio. This was coined by Peter Lynch, the legendary investor who practically pulverized the market with his Magellan Fund, achieving a 29% annualized return . So when he speaks, we listen.
Let's go back to the P/E ratio. The P/E ratio shows us how the annual surplus or profit relates to the market capitalization . And from that we create a metric that shows us approximately how expensive or cheap the company is at a given moment. The pitfall of the P/E ratio, however, is the lack of a crucial metric: growth!
Let's look at companies A and B again. Let's assume company A grows at 0% annually; then a P/E ratio of 15 is by no means favorable, since this valuation remains constant , whereas with company B, which grows at around 25%, we suddenly have a very attractive valuation. With a P/E ratio of 15, the company remains at its valuation for many years , whereas the initial P/E ratio of 25, with an annualized growth rate of 25%, falls to 12.8 in the third year and lands at 8.2 in the fifth year.
The company is literally growing into its valuation, which then becomes increasingly favorable. Peter Lynch coined the term PEG ratio to express precisely this relationship between growth and profit . It is calculated by taking the price-earnings ratio and adding the annual earnings growth rate, and then relating the two.
So, you divide the P/E ratio by the earnings growth rate. Based on this value, Lynch's book One Up On Wall Street provides guidance. A PEG value of 1 or less is considered extremely favorable. From 1 to 1.5 we are definitely fairly valued and above 2, which is almost normal nowadays, especially in the USA, is, according to Lynch, an overvaluation .
Let's look at three examples in the current market . Alphabet is trading at a forward P/E ratio of about 22, and if you take the long-term earnings estimates, we have about 15%. This means that we end up with a PEG ratio of 1.46, which is a quite fair valuation, even though the big ship is generally considered to be richly valued.
However, if we look at Tesla, we see an extremely high P/E ratio, and if we compare that to current earnings estimates , we still end up with a PEG ratio that actually makes the stock unbuyable. Hidden away in the second and third rows, we find some great gems, such as Krones AG, a world market leader in the field of filling technology.
This includes companies like Coca-Cola, with a forward P/E ratio of 10 and annualized growth rates of 8 to 10%, resulting in a PEG ratio close to 1. This is therefore a quite favorable value. Now we come to the big catch. Firstly, G is always an estimate. We don't know if things will stay the same in the following year, and the second catch is that quality always tends to trump and distort the key performance indicators to some extent.
Quality justifies higher multiples, so one must always be aware that Alphabet at 1.46 might even be more attractive than Kronis at 1.0 or 1.2. And so, in the end, one can say that what Peter Lynch says in his highly readable book " One Up On Wall Street" is: "Know what you own and why you own it." That's always true.
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