Lynch-style growth at a fair price

What this checklist is trying to capture

Peter Lynch ran Fidelity's Magellan fund from 1977 to 1990, and in One Up on Wall Street he explained how he looked for growing companies without overpaying for them. His best-known yardstick compares a stock's price-to-earnings ratio with the company's earnings growth rate: a company growing quickly deserves a higher P/E, but only up to a point. He also checked that the growth was sustainable, that the balance sheet wasn't stretched, and that nothing in the accounts hinted at trouble ahead.

The tests, and exactly how we compute them

"Year t" is the latest fiscal year in the company's SEC filings.

1. PEG ratio below 1: the P/E (today's price divided by diluted EPS in year t) divided by the yearly EPS growth rate over the last five years, expressed as a number (20% growth counts as 20). Lynch described a P/E roughly equal to the growth rate as fairly priced, and a P/E well below it as a bargain. A company whose earnings didn't grow fails.
2. Earnings growing 15% to 30% a year: compound yearly growth in diluted EPS over the last five years. Lynch liked fast growers but was wary of very high growth rates, which rarely last and attract competitors. The upper limit of 30% is our reading of that caution.
3. Debt-to-equity below 0.33: total debt divided by shareholders' equity. Lynch described a normal company balance sheet as about three-quarters equity and one-quarter debt; 0.33 is that proportion written as a ratio.
4. Inventory not growing faster than sales: the yearly change in inventory is no larger than the yearly change in revenue. Lynch saw inventory piling up faster than sales as an early warning that demand was slowing. Companies that report no inventory, such as most software, services and financial firms, show "n/a".

Reading the score

The PEG test and the growth test pull against each other on purpose: a company can pass the PEG test because its growth is exceptional, then fail the growth test because that rate is unlikely to last. Read the explanations on each stock's page to see which side it falls on.

Limitations

• Lynch looked at expected future growth as well as past growth; we use the last five years of reported earnings only.
• Dividends add to the return Lynch counted in some versions of his ratio; this test uses earnings growth alone.
• Earnings that rebound from a bad year can show a very high growth rate that says little about the business.

See how we score for data sources and update timing.