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Peter Lynch Fair Value – Value Companies with Peter Lynch’s Simple Rule of Thumb
Posted by: GuruFocus (IP Logged)
Date: July 11, 2012 01:38PM

In our new Valuation Box feature we are displaying a valuation parameter called “Peter Lynch Fair Value.” In the updated 10-year financial page we have also added the historical quarterly Peter Lynch Fair Value of companies. We have gotten a lot of questions about “Peter Lynch Fair Value,” so we would like to clarify the concept with this article.

Before we start, this is the valuation box for WalMart (WMT).

How to calculate “Peter Lynch Fair Value”?

Peter Lynch Fair Value is calculated based on Lynch’s famous rule of thumb: He is willing to buy a growth company at a P/E multiple that is equal to its growth rate. Therefore, to Peter Lynch, at fair value, the PEG ratio of a growth company should be 1.

Because of this, the calculation of Peter Lynch Fair Value is very straightforward. It simply equals to the growth rate multiplied by its earnings. That is:

Peter Lynch Fair Value = Earnings Growth Rate * Earnings.

Therefore, if a company grows its earnings 20% a year, to Peter Lynch, its fair valuation is 20 times its earnings.

In our articles New Feature Added: Valuation Box and How to calculate the intrinsic value of a stock?, we wrote the formula in this format:

Peter Lynch Fair Value = PEG * Earnings Growth Rate * Earnings.

In this formula, PEG =1, as we should note even more.

What you need to know about “Peter Lynch Fair Value”

Please note that we use EBITDA growth rate as the earnings growth rate here. The reason we use EBITDA growth rate is because this rate is less subject to management manipulations and distortions from one-time corporate events.

Just as any other valuation methods we use in the Valuation Box, Peter Lynch Fair Value has its limitations. It tends to underestimate slower growing companies, and overestimate fast growing companies. And it assumes that the company will grow in the future as fast as it did in the past, which is usually not the case.

In our calculations, we only apply Peter Lynch Fair Value to companies that grow between 8% a year and 25% a year. If a company grows faster than 25% a year, e.g. Apple (AAPL) and Questcor Pharmaceuticals (QCOR), we use 25 for the PE multiple.

Peter Lynch Fair Value has been displayed for all the stocks when this is applicable. It is also in the new “Valuations” tab for Gurus’ portfolios. For instance, Peter Lynch Fair Values of all Warren Buffett’s stocks are here.

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Re Peter Lynch Fair Value Value Companies with Peter Lynch s Simple Rule of Thumb
Date: July 12, 2012 01:30AM

Hi, great post.
Anyway Peter Lynch included also the dividend yield, the growth rate resulting the sum of the two.
John Neff used practically the same ratio, taking into consideration the earnings growth and the dividend
yield scaled the p/e ratio of the company. They also suggested the optimal ratio between the two figures
was less than 1. It is a very effective rule of thumb, and also gives enough margin of safety considering that if the ratio is significantly less than one there's room to profit also from the p/e multiple expansion.

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Re Peter Lynch Fair Value Value Companies with Peter Lynch s Simple Rule of Thumb
Posted by: cjmitchell86 (IP Logged)
Date: July 12, 2012 10:38AM

what growth rate do you use? y/y? 3 YEAR CAGR? 5 year CAGR? 10 year CAGR?....

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Re Peter Lynch Fair Value Value Companies with Peter Lynch s Simple Rule of Thumb
Posted by: gurufocus (IP Logged)
Date: July 12, 2012 11:12AM

"what growth rate do you use? y/y? 3 YEAR CAGR? 5 year CAGR? 10 year CAGR?...."

As pointed out, 5-year CAGR on EBITDA.

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Re Peter Lynch Fair Value Value Companies with Peter Lynch s Simple Rule of Thumb
Posted by: cjmitchell86 (IP Logged)
Date: July 12, 2012 11:56AM

In defense of my question, EBITDA was pointed out, the duration of growth was not.

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