One Up on Wall Street Ch. 5: The Numbers That Matter

"You don't need to be a mathematician. If you can do fifth-grade arithmetic, you have all the math required to invest." — Peter Lynch

Investment Context

Lynch is known for "buy what you know," a phrase routinely misread as "buy the stock of a product you like." Lynch himself rejected that reading: noticing an interesting company is where research begins, not where it concludes.

This chapter covers the quantitative checks between "I notice this store always has a line" and "this stock is worth owning."

The Wall Street Translation

1. The PEG Ratio: Growth and Valuation Together

• Formula: PEG = P/E ÷ annual earnings growth rate
• Lynch's thresholds: below 1 is attractive, below 0.5 highly attractive; above 2 usually warrants avoidance.

Why it matters: P/E alone misleads. A company at 30× earnings growing 40% (PEG 0.75) is cheaper than one at 12× growing 5% (PEG 2.4).

This settles the perennial "aren't growth stocks expensive" debate — the answer depends on the growth rate, not the multiple in isolation.

2. Debt Structure: The Check He Never Skipped

Lynch stressed that the balance sheet determines whether a company survives long enough for your thesis to be proven.

• Debt-to-equity: below 0.5 for an ordinary company; above 0.8 requires a strong justification.
• Composition of debt: bank lines can be pulled at will, long-dated corporate bonds cannot — the same debt amount carries entirely different risk.
• Cash: a cash-rich company can buy competitors cheaply during a downturn.

3. The Other Metrics He Actually Used

| Metric | What it reveals | |---|---| | Inventories | Growing persistently faster than sales is an early demand-slowdown signal | | Free cash flow | Profits can be managed; cash is harder to fake | | Same-store sales | The most honest health measure for retail and chains | | Institutional ownership | Lower is better — undiscovered companies still have room |

The last runs against most intuition: Lynch preferred companies with low institutional ownership and thin analyst coverage, because that is where a fund manager could still hold an informational edge.

4. The Quantitative Version of the Two-Minute Drill

Before buying, you should be able to state: how the company makes money, its growth rate, its PEG, its debt level, and what would prove your thesis wrong.

If you cannot state all five, the research is not finished.

5. A Worked PEG Calculation

Consider two companies:

| | Company A | Company B | |---|---|---| | P/E | 32 | 11 | | Earnings growth | 35% | 4% | | PEG | 0.91 | 2.75 |

On the surface B is three times cheaper; on PEG, A is the cheap one.

Lynch attached an important constraint: the growth rate must be sustainable, and should reflect the next several years rather than a past peak. Computing PEG from an unsustainable growth rate yields a misleadingly low figure — the most common misuse of the ratio.

The conservative practice: use the lower of management guidance and the industry growth rate.

Actionable Trading Rules

1. Judge growth stocks by PEG, never P/E alone: Multiples are not comparable across different growth rates.
2. Check debt before growth: Rapid growth cannot save a company whose credit lines are pulled during a squeeze.
3. Favor the overlooked: The lower the institutional ownership and analyst coverage, the more your independent work can produce an edge.