TL;DR: GARP means investing in companies with growing earnings, at a price that is reasonable relative to that growth. The PEG ratio (P/E divided by expected earnings growth in percent) is the common yardstick. It rests on an estimate and guarantees nothing.
What can you expect?
- Time per week
- About 2 to 4 hours a week in the early phase, afterwards around results releases.
- Starting capital
- No fixed minimum. With small amounts, order costs weigh heavily and diversification is difficult. Only invest money you can afford to lose.
- Typical setbacks
- Disappointing earnings, falling prices when growth slows, and years without results. Growth shares can fall 30% or more.
- Costs
- Order costs, spread, currency costs on foreign shares, custody fees and withholding tax on dividends. Compare the costs of several brokers.
- Not suitable if…
- People who expect quick results, do not want to read annual reports or cannot bear a sharp fall in price.
How it works
GARP (growth at a reasonable price) looks for a middle road between growth investing and value investing. In One Up on Wall Street (1989), Peter Lynch described the PEG ratio: the price/earnings (P/E) ratio divided by expected annual earnings growth in percent. He called a share whose P/E equals its growth fairly priced. A PEG below 1 he saw as attractive and well above 1 as expensive. The PEG ratio was already in use before; Lynch made it widely known. The ratio depends on an estimate of growth, and that estimate can be wrong. This is education, not investment advice.
Core principles
- 1. Look for earnings growth the company can probably sustain
- 2. Compare the price with growth, for example using the PEG ratio
- 3. Do not overpay, even for a great company
- 4. Buy companies you can explain
Step-by- step plan
- 1
Learn to calculate the PEG ratio
Divide the P/E (price divided by earnings per share) by expected annual earnings growth in percent. Practise with companies you know. Use cautious growth estimates.
- 2
Build a candidate list
Filter for positive earnings over several years, reasonable growth and a PEG around or below 1. Extreme growth figures are often not sustainable.
- 3
Understand the company
Explain in a few sentences how the company makes money and what its advantage is. Read the annual report, especially the parts on strategy and risks.
- 4
Set position size and diversification
Spread your money over several shares and keep each position small. Some picks will disappoint.
- 5
Follow the numbers and review at fixed moments
Recalculate the PEG whenever results are published. Review your position if growth falls back, the PEG rises sharply or your reasoning no longer holds.
In detail
The PEG ratio explained
The PEG ratio is the P/E divided by expected annual earnings growth (in percent). A share with a P/E of 20 and 20% growth has a PEG of 1. With a P/E of 20 and 10% growth, the PEG is 2.
The ratio allows a quick comparison between shares with different growth. A low P/E can be expensive with little growth, and a high P/E can be reasonable with strong growth. The ratio is crude, though: it says nothing about debt, cash flow or how certain the growth is.
What Lynch described
In One Up on Wall Street (1989), Peter Lynch, who managed Fidelity's Magellan fund, described how ordinary investors can find companies from their own surroundings: shops, products and services they understand. He called a share whose P/E equals its growth fairly priced and distinguished kinds of companies (slow growers, stalwarts, fast growers and more). We make no statements here about returns of individual funds or shares: past results say nothing about the future.
When paying for growth goes wrong
If you pay a high P/E for fast growth, the growth has to come and the market has to stay willing to pay for it. If growth disappoints, the earnings expectation falls and often the P/E too. Both effects work at once. The worked example below shows this with made-up figures.
That is why investors also look at the balance sheet, cash flow and the durability of the business model, not only the PEG.
Limits of the method
Growth estimates often come from analysts and in practice are often too optimistic. Earnings can be temporarily high because of one-off items. For smaller companies there are fewer estimates. For companies with losses or very low earnings, the PEG is not usable.
So use the ratio as a first filter and then read the annual report.
- Basic knowledge of P/E and earnings growth
- Able to work with percentages
- Patience for a horizon of several years
- Stock screener with P/E and growth figures
- Annual reports and earnings releases
- Spreadsheet for PEG and scenarios
- 01 PEG ratio around or below 1, based on a cautious growth estimate
- 02 Earnings growth you can support and that is not a one-off
- 03 A P/E that fits the growth
- 04 A healthy balance sheet and a clear business model
- 05 You can explain in a few sentences how the company makes money
- 01 Review the position if the PEG ratio rises sharply (for example above 2)
- 02 Review if earnings growth clearly falls back
- 03 Review if your original reasoning no longer holds
- 04 Rebalance if a position grows too large
Worked example
Made-up worked example (not advice, not a forecast). A company has earnings per share of €1.50 and a price of €30. Expected earnings growth is 25% a year.
Formulas: P/E = price / earnings per share. PEG = P/E / earnings growth (%).
- P/E = €30 / €1.50 = 20
- PEG = 20 / 25 = 0.8
For comparison: a company with a P/E of 30 and 15% growth has a PEG of 30 / 15 = 2.0.
What if growth disappoints? Look three years ahead.
- At 25% growth a year: earnings = €1.50 × 1.25³ = €2.93. If the P/E stays 20, the price is €58.59 (+95%). If the P/E falls to 12, the price is €35.16 (+17%).
- At 15% growth a year: earnings = €1.50 × 1.15³ = €2.28. If the P/E falls to 12, the price is €27.38 (−8.7%).
Earnings rise in both cases and yet the price can fall if growth disappoints and the market is willing to pay less. These are made-up figures, not a forecast. Costs and tax are not included.
Hypothetical example, not advice.
Work it out yourself
Risks and risk management
- The PEG ratio depends on an estimate of growth, and that estimate can be wrong
- If growth disappoints and the P/E falls, the price can fall sharply
- You can lose a large part or all of your investment in one share
- Analyst forecasts are often too optimistic
- Growth shares can swing strongly
- Costs (order costs, spread, currency) count, especially on small amounts
- Spread across several shares and keep each position small
Learn the basics
Key takeaways
- The PEG ratio sets the price against growth: P/E divided by expected earnings growth in percent.
- The result is only as good as your growth estimate. Do not stretch growth to make a share look 'cheap'.
- If you pay a lot for growth, everything has to go right. If growth disappoints, the P/E often falls too, and so does the price.
- Lynch stressed that you should understand what you invest in. A number is a starting point, not an answer.
Frequently asked questions
How do I calculate the PEG ratio myself? +
PEG = P/E divided by expected annual earnings growth in percent. Example: P/E 20 and 25% growth gives 20 / 25 = 0.8. P/E 30 and 15% growth gives 30 / 15 = 2. Use a cautious estimate of growth for the coming years and compare it with past growth.
What is the difference between GARP and pure growth investing? +
Pure growth investors mainly look at growth and sometimes pay a high price for it. GARP investors also watch the price relative to growth. That reduces the risk of overpaying, but does not remove it. Both approaches can lead to losses.
How long do I hold a GARP share? +
That depends on your reasoning. Review your position at fixed moments, for example at every results release, and if growth falls back, the PEG rises sharply or the story changes. You can also rebalance when a position grows too large. Allow for costs and tax.
Origin
Devised by / based on: Peter Lynch . Source: One Up on Wall Street (Peter Lynch met John Rothchild, 1989)