How To Use PEG Ratios

| December 3, 2008 | 0 Comments

About five years ago I was attending an investor conference in Boston. The place was packed, and hot.  Two words come to mind when thinking of Boston in August… hot and humid.  The air conditioning struggled to keep the rooms moderately cool.  It was stifling in my suit and tie.

I was one of about 2,000 people in attendance.

The attendee mix was quite elite.  Money managers and institutional investors all mulled around the lobby and sat in conference rooms.  CEOs and CFOs rushed in and out of meetings.  Everyone had a schedule.  It was well orchestrated chaos.

That’s when I met one of the greatest investors of all time.

It was Peter Lynch.  He was dressed in classic Lynch style.  His hair was mussed, the black framed glasses contrasted with his cream colored suit. He didn’t wear a tie, but on his feet were sandals… Birkenstocks.  My first impression was a mad professor!

I guess when you’re as successful and famous as he is, nobody cares what you wear.

Lynch started his career with the huge money manager Fidelity in 1966 as an intern.  A few years later he joined the firm full time as an analyst, eventually moving to director of research in 1974.  In 1977 he was picked to head up a small fund called Magellan.

The Magellan Fund had under $20 million in assets when he started. Lynch decided to retire from the day to day management in 1990.  By then the tiny Magellan fund had grown to more than $14 billion in assets and 1,000 different stock positions.

His performance was nothing short of spectacular.

Everyone wanted to know about his investing secrets.  So he penned a few books talking about his style and strategy.  They’re all good reads… if you come across them in the library or in a book store pick them up. You won’t be disappointed.

In these books, Lynch popularized a somewhat obscure investing method.  A method you can use in your own portfolio today.  But more on that in a moment.

Lynch was famous for the amount of research he conducted.  He relied on many different analyses and looked at tons of data.  Two popular metrics he looked at were P/E (Price to Earnings) ratios and growth rates.

By combining the two metrics into a PEG ratio, he was able to make comparisons between the companies.

I know what you’re thinking… what’s a PEG ratio?

A PEG ratio is a tradeoff between valuation metrics.  We all know a low P/E ratio means a company’s potentially undervalued.  A high growth rate is a strong sign of improving financial metrics.  Unfortunately, you’ll be hard pressed to find a company with a big growth rate and a low P/E.

By taking the P/E ratio and dividing it by the growth rate you get a better idea of true value.

You’ll be able to identify companies who’s valuations are high (or low) when compared to their growth rates.  Lynch was noted as saying (and I’m paraphrasing here) a company with a P/E ratio equal to its growth rate is fairly valued.

In other words a PEG ratio of 1.0x indicates a company isn’t over-priced or under-priced.  If you find a company with a PEG ratio of less than one, it might be a great buying opportunity.

I know some of this seems complex.  Don’t get flustered.

A lot of the major online financial sites calculate PEG ratios for you.  Just as an example, Yahoo Finance publishes PEG ratios in their key statistics section.

There’s a number of companies out there with low PEG ratios.  One that jumped out at me was NutriSystem Inc. (NTRI).  They provide fitness products and services targeted at people looking to lose weight.  The company has a P/E ratio of just under 8x.  It’s estimated over the next 5 years the company will grow at 17% per year.  This gives the company a PEG ratio of just over 0.47x.

It’s a perfect example of a company with a nice growth rate being mis-valued by the market.  Take a look at NutriSystem, it might be a good addition to your portfolio.

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Category: Stocks

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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