Is GROWTH OVERRATED? No, GROWTH IS EVERYTHING!

• Author: Lavely, Sr, Joe

Investment analysts often repeat the advice of Peter Lynch, Fidelity's guru extraordinaire, to seek stocks with earnings growth rates that are twice, or at least above, their Price/Earnings (P/E) ratios. Several Internet investment advisory sites routinely provide "PEG" ratios, P/Es divided by growth rates, to gauge this metric. Just how good is this strategy? Can it be applied inside the firm as well as outside? As Table 1 demonstrates, the strategy is outstanding and, yes, it can be applied inside the firm.

Suppose you are considering acquiring a business unit. How much is too much to pay for it? Certainly, you won't find any magical answer here, but you will find a fresh use of familiar financial concepts that may help you ascertain a reasonable amount.

This valuation approach takes its clues from the stock market and helps value the potential investment by applying a P/E ratio to the business unit's earnings, then comparing this ratio to that of the overall market. [A refinement that some analysts might prefer is to use Earnings Before Interest and Taxes (EBIT) rather than earnings. And, unfortunately, the approach applies to only those businesses with positive earnings; it is of no use in valuing units with negative earnings.]

"Nothing new in that," you say? Well, you are right. What is new is insight into just how high a P/E is appropriate -- depending on how rapidly the business unit's earnings are growing.

Let's start with the price of the "average" asset. The S&P 500 Index is about as average as you can get. Currently, it has a P/E of about 35. That means that for every dollar of price, it provides almost three cents of earnings: its E/P ratio (simply the reciprocal of the P/E ratio) is .0286. Further, it is reasonable to estimate that, at best, these earnings will advance about seven per cent per year: say, five per cent real growth and two per cent due to inflation.

Now, suppose that you have an opportunity to purchase a business at 50 times its current earnings. Is it worth a P/E of 50? Well, among other factors, it depends on how fast these earnings are growing. In general, businesses with higher growth rates command higher prices, and therefore higher P/Es. So, how fast would the businesses have to grow in order for the opportunity to be a good deal? Obviously, the firm's earnings would have to rise faster than the S&P 500's, faster than 7% per year. But, how much faster?

Here's where the Table comes in. The Table's cells give...