One of the problems we've always faced with out valuation tools is distinguishing when the Fool Ratio (PE / Growth) is appropriate for a stock and when it isn't. For the most part, we haven't used the Fool Ratio for the DJIA heavyweights because the ratio seems more suited for small-cap growth stocks. It certainly doesn't work well for cyclical stocks. So, we've often turned to the YPEG, trying to push the earnings estimates out further and take some of the wide swings out of the equation that can occur with the Fool Ratio.
I'm not comfortable with the YPEG either as a good method for many of these Dow stocks for the same reasons we don't use the Fool Ratio. It doesn't work well with cyclicals, but more importantly, we love the Dow stocks for their dividends, something ignored by the equation altogether. But there is a way to pull dividends back into this valuation tool. Peter Lynch argues in his book One Up On Wall Street that comparing the long-term growth rate, dividend yield, and PE ratio can provide a reasonable valuation tool, even for these large-caps (including the cyclicals).
So, how do we do it? Lynch's formula is simply the sum of the 5-year Growth Rate and the Dividend Yield, divided by the PE ratio.
5-Year Growth Rate + Dividend Yield
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PE Ratio
Anything over 1 is decent, but an even higher number is what we're looking for. For the Dow heavyweights, you won't find a number over 2 very often, but applying this formula to other stocks will yield some very attractive candidates at times.
If you want to keep the scheme consistent, you can flip-flop the equation so the PE is on top and the growth rate and yield are on the bottom. That way, the lower the score, the better, which is the way our usual PEG ratio is listed.
After a series of conversations with Morely about this method, I decided to follow a basket of DJIA stocks using this approach. So you'll see an entry for Lynch 5 and Lynch 10 each week in my Dow updates. And periodically I'll post the current list of stocks using this valuation tool in the Dow folder. It'll be fun to watch, and so far in 1996, it's been a good performer. Watch along with us as we try to Lynch the Dow.