Finding bargains amongst good companies is difficult because they report great earnings increases and the share prices start to climb. So do you chase after the high-flyers, paying whatever the price of admission is required to be part of the growth story?
For strong growth, you have to pay a reasonable price, or you will exclude yourself from many opportunities. You still need a way to gauge the risk and reward of paying up for growth potential. The author of One Up on Wall Street, Peter Lynch, a well-known former fund manager at Fidelity Investments, used a general rule of thumb that the price/earnings ratio (PE) should roughly be the annual earnings growth rate to be a reasonable buy.
He used the annual earnings of a company, not the earnings per share. He also used historical averages rather than forward earnings forecasts. I prefer historical data because it is the actual result through up years and down years, whereas forecasts don't have great certainty and are usually for only the next year.
We also want to throw in dividend yields because that represents income while we patiently wait for future share price gains.
Add up the earnings growth rate and the dividend yield, then divide that by the current PE ratio. If the value is 1-1.5, that's reasonable. 1.5-2 is ok and 2 or better may be showing you a bargain. Less than one becomes a poor trade-off.
Here's how four companies fared with their trade-off of growth and income for price.
As an example, Flight Centre Travel Group Ltd (ASX: FLT) had an underlying net profit growth rate of about 22% over the past nine years, its dividend yield is 2.7% and the PE ratio is 20.4.
22 +2.7 is 24.7. Dividing that by 20.4 gives 1.21. It indicates that the share price is reasonable compared to past earnings growth.
Foolish takeaway
A value around 1 or more means for the past earnings track record, the PE ratio is not that extravagant. You are paying roughly in line with how the company has performed in the past.
This doesn't predict next year's earnings growth. Since we can't foretell future results, long-term past performance is commonly a more reliable indicator of future earnings trends.
