John Reese is founder and CEO of Validea.com and Validea Capital Management, and portfolio manager for the Omega American & International Consensus funds offered in the Canada.
Since the dawn of securities analysis, the price-to-earnings ratio has been the most widely cited variable in stock market parlance.
Check the business section of your daily newspaper and you'll likely find that the P/E is the only valuation metric listed along with each stock's price. Read most stock recommendation columns or listen to TV pundits, and you'll hear the P/E ratio cited scores of times every day.
Given its ubiquity in the investment world, it's easy to think that the P/E ratio is the be-all and end-all of valuation tools.
But using the ratio in a vacuum can be dangerous, something the great Peter Lynch realized years ago.
Peter Lynch
Mr. Lynch was one of the greatest mutual fund managers ever, guiding Fidelity's Magellan fund to average annual returns of more than 29 per cent from 1977 to 1990, almost double the returns of the S&P 500.
Mr. Lynch found that P/E ratios didn't tell the whole story about a stock. Companies growing quickly, for example, often sold for fairly high P/E ratios but kept on rising, as long as their earnings kept growing.
A great example, Mr. Lynch notes in his book One Up on Wall Street , is Wal-Mart. He says that the retailer's P/E was rarely below 20 during its three-decade rise, which wouldn't be considered low in most circles.
But during that period, Wal-Mart was consistently growing earnings at a nearly 30-per-cent clip every year, generating big profits despite its P/E ratio not being particularly low.
Mr. Lynch's conclusion: It's okay to pay a premium for a stock – so long as the company is producing.
To capture that concept, he developed the “P/E/G” ratio, which divides a stock's P/E ratio by its growth rate. If a stock's P/E/G was below 1.0 (meaning its P/E ratio was even with or less than its growth rate), Mr. Lynch saw that as acceptable. And if the P/E was half or less of the growth rate (that is, if its P/E/G was 0.5 or lower), that really piqued his interest.
Essentially, the P/E/G tells you how much you're paying to get a piece of a company's growth, and Mr. Lynch found it to be a great way to identify growth stocks still selling at a good price.
In fact, the P/E/G ratio became the most important fundamental variable he considered when looking at a stock. It's the key variable in my Lynch-based “Guru Strategy” computer model, which is up almost 40 per cent this year.
It can also be interesting to use the P/E/G to take a snapshot of the broader market. For example, the S&P 500 closed the week of Oct. 26-30 at about 1,036 points.
Estimates for the index's 2010 operating earnings are $73.54 per share, up from $54.87 in 2009. Allowing room for 15-per-cent error either way, that means the S&P appears to be selling at a P/E/G range of about 0.23 to 1.19 – not bad for the overall market.
Different Strokes for Different Stocks
When it comes to assessing individual stocks, one important facet of Mr. Lynch's P/E/G approach is that he applied the ratio differently to various types of stocks. For larger companies with moderate or lower growth rates, he adjusted the “G” portion of the P/E/G equation for dividend yield, because they often pay high yields.
For faster-growing firms (those growing at 20 per cent a year or at a greater clip), he didn't factor in dividend yield, since they typically reward shareholders with growth in stock value, not dividends.
