Companies with better prospects should sell with higher price-earnings ratios. A useful valuation technique is to compare the price-earnings ratio to the earnings growth rate. A price-earnings ratio of half the level of historical earnings growth is considered attractive, while ratios above two are considered unattractive.
Lynch refines this measure by adding the dividend yield to the earnings growth. This adjustment acknowledges the contribution that dividends make to an investor's return. The ratio is calculated by dividing the price-earnings ratio by the sum of the earnings growth rate and the dividend yield. With this modified technique, ratios above one are considered poor, while ratios below 0.5 are considered attractive. Our screen uses this ratio of price-earnings to the earnings growth rate plus the dividend yield. A ratio less than or equal to 0.50 is specified as a cut-off.
It is important to examine the historical record of earnings. Stock prices cannot deviate very long from the level of earnings, so the pattern of earnings growth will help to reveal the stability and strength of the company. Ideally, earnings should move up consistently. We did not use any earnings stability screens, however the table of passing companies includes seven years of earnings per share data.
Lynch prefers to invest in companies with earnings expanding at moderately fast rates (20% to 25%) in non-growth industries. Extremely high levels of earnings growth rates are not sustainable, but continued high growth may be factored into the price. A high level of growth for a company and industry will attract a great deal of attention from both investors, who bid up the stock price, and competitors, who provide a more difficult business environment. Our final filter specifies a maximum earnings per share growth rate of 50%.