In Peter Lynch's One Up on Wall Street, he gave a simple, straight-forward explanation as to his preferred metric for doing a quick and dirty valuation of a firm's investment prospect:

A slightly more complicated formula enables us to compare growth rates to earnings, while also taking the dividends into account. Find the long-term growth rate (say, Company X's is 12 percent), add the dividend yield (Company X pays 3 percent), and divide by the p/e ratio (Company X's is 10). 12 plus 3 divided by 10 is 1.5.

Less than a 1 is poor, and a 1.5 is okay, but what you're really looking for is a 2 or better. A company with a 15 percent growth rate, a 3 percent dividend, and a p/e of 6 would have a fabulous 3.

However, I'm not sure he gave the name for it. I got the book out of the library and only copied down the quote. Is this the Dividend Adjusted PEG Ratio he's talking about?


Essentially, yes, Peter Lynch is talking about the PEG Ratio.

The Price/Earnings to Growth (PEG) Ratio is where you take the p/e ratio and then divide that by the growth rate (which should include any dividends). A lower number indicates that the stock is undervalued, and could be a good buy.

Lynch's metric is the inverse of that: Growth rate divided by the p/e ratio. It is the same idea, but in this case, a higher number indicates a good value for buying.

In either case, the idea behind this ratio is that a fairly priced stock will have the p/e ratio equal the growth rate. When your growth rate is larger than your p/e ratio, you are theoretically looking at an undervalued stock.

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