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I recall that the P/E of a growth stock should generally match its earnings growth rate. So, for example, let's say you a stock growing its earnings by 40% a year, then its P/E should also be about 40.

Do you remember the reason / calculation? Or if you disagree with this general assessment, please indicate that. I just recall it as the "general rule", but am trying to work out the underlying "whys" of that.

Thanks

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This is only a rule of thumb. Peter Lynch popularized it; the ratio PE/growth is often called the Lynch Ratio. At best it's a very rough guideline.

  • It completely ignores the balance sheet.
  • It makes no distinction between accounting earnings and cash flow.
  • It doesn't consider qualitative characteristics like management competence.

I could fill up this page with other caveats. I'm not saying that it's wrong, only that it's grossly incomplete. For a 10 second eyeball valuation of growth stocks, it's fine. But that's the extent of its usefulness.

  • 1
    Thanks Eric, could you further explain significances between earnings and cash flow. I'd love to understand that more. Is cash flow just earnings, in advance -- i.e. having enough money to "pay the bills/spend" on time? – Ray K Oct 10 '11 at 22:36
  • Lots of small differences between earnings and cash flow (see investopedia.com/articles/01/110701.asp#axzz1aQH6fxa5 for more detail). A few quick examples - depreciation of equipment affects earnings but not cash flow, accounts receivable can be included in profits but are not actually cash, etc. – Dan Carroll Oct 10 '11 at 23:03
  • @DanielCarroll is right. Cash flow is just how much cash came in vs. how much cash went out. Accounting earnings consider all kinds of non-cash items - depreciation, goodwill, etc. – Eric Oct 11 '11 at 14:47
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Your observation is mostly right, that 1 is a the number around which this varies. You are actually referencing PEG, P/E to Growth ratio, which is a common benchmark to use to evaluate a stock. The article I link to provides more discussion.

  • Ah, thank you, didn't know about PEG. – Ray K Oct 10 '11 at 22:37
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To perhaps better explain the "why" behind this rule of thumb, first think of what it means when the P/E ratio changes. If the P/E ratio increases, then this means the stock has become more expensive (in relative terms)--for example, an increase in the price but no change in the earnings means you are now paying more for each cent of earnings than you previously were; or, a decrease in the earnings but no change in the price means you are now paying the same for less earnings.

Keeping this in mind, consider what happens to the PE ratio when earnings increase (grow)-- if the price of the stock remains the same, then the stock has actually become relatively "cheaper", since you are now getting more earnings for the same price. All else equal, we would not expect this to happen--instead, we would expect the price of the stock to increase as well proportionate to the earnings growth. Therefore, a stock whose PE ratio is growing at a rate that is faster than its earnings are growing is becoming more expensive (the price paid per cent of earnings is increasing). Similarly, a stock whose PE ratio is growing at a slower rate than its earnings is becoming cheaper (the price paid per cent of earnings is decreasing). Finally, a stock whose P/E ratio is growing at the same rate as its earnings are growing is retaining the same relative valuation--even though the actual price of the stock may be increasing, you are paying the same amount for each cent of the underlying company's earnings.

  • Andrew, I think I mostly got it, but can I ask an example; lets say a company's earnings growth rate goes from 50% to 100%; can you expand on how you see the P/E adjusting. Should the price then change each quarter new earnings data is available, to make the ratio match the new earnings growth rate? – Ray K Oct 10 '11 at 22:41

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