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Behind the Numbers: Peter Lynch and Fair Value

Peter Lynch provided investors with two popular ways to measure a stock's value

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Jul 08, 2021
Summary
  • The Peter Lynch Fair Value assumes the fair price-earnings ratio for a growth company equals its growth rate.
  • The Peter Lynch chart compares a stock’s price to what its price would hypothetically be if it traded at its earnings line.
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The GuruFocus site gathers together a wide variety of information and calculations that investors can use to help determine whether or not investing in a specific stock is the right choice for them.

Of these metrics, two come from Peter Lynch, the highly successful manager of the Magellan Fund who averaged a 29.2% annual return between 1977 and 1990. These are the Peter Lynch Fair Value, created based on the idea that the fair price-earnings ratio for a growth company equals its growth rate, and the Peter Lynch chart, which compares a company’s price line to its earnings line.

Peter Lynch fair value

The Peter Lynch fair value is a valuation method meant to be applied to growing companies, with the ideal growth rate being between 10% and 20%. This valuation method assumes that the fair price-earnings ratio for a growth company equals its growth rate, i.e., its PEG ratio is 1.

The Peter Lynch fair value is calculated as follows:

“Peter Lynch Fair Value = PEG Ratio * 5-Year EBITDA Growth Rate * EPS without NRI (TTM)”

For non-bank companies, the growth rate that GuruFocus uses is the average growth rate for Ebitda per share over the past five years. For banks, GuruFocus instead uses the average growth rate for book value per share over the past five years. The five-year growth rate is capped at 25% per year, and if it is below 5% a year, the Peter Lynch Fair Value is not calculated.

The Peter Lynch chart

The Peter Lynch chart is sometimes confused with the Peter Lynch Fair Value, but these are two entirely separate valuation methods.

Describing what would later become known as the Peter Lynch chart in pages 164 and 165 of his book “One Up on Wall Street,” Lynch wrote:

“A quick way to tell if a stock is overpriced is to compare the price line to the earnings line. If you bought familiar growth companies – such as Shoney’s, The Limited, or Marriott – when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you’d do pretty well.”

GuruFocus’ Peter Lynch chart compares the stock’s price line to two hypothetical lines: the first is what the stock price would be if it traded with a price-earnings ratio of 15 (which Lynch dubs the “earnings line”), while the second is what the stock price would be if it traded at its median price-earnings ratio without non-recurring items from the past decade.

Uses and pitfalls

The Peter Lynch Fair Value gives us an estimate of the intrinsic value of a growth stock. It can be useful in identifying growth stocks that are trading at low prices compared to what their growth is worth, provided that said growth continues into the years ahead.

Thus, if a company’s business is expected to grow at a faster rate in the future that it has in the past, investors who have done their thorough due diligence on the company might still find a stock cheap even if it is trading above its Peter Lynch Fair Value. However, such growth is rare, so in most cases, if a stock is trading above this valuation estimate, it means that future returns will rely on investors continuing to pay elevated multiples for the stock.

One of the drawbacks of this method is that it isn’t useful for dividend-paying stalwarts that are chugging along at a growth rate below 5%. Additionally, if a company is growing its earnings too rapidly, the Peter Lynch Fair Value cuts it off at 25% per year. This helps to steer clear of the effects of one-off years or other extenuating circumstances, but some growth investors might not like the cutoff and may choose to do away with it in their own calculations of fair value.

To compare the price of a stock to its Peter Lynch Fair Value, GuruFocus users can select these two lines on a stock’s interactive chart:

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On the stock summary pages, the price-to-Peter-Lynch-Fair-Value ratio is shown in the “valuation & return” section:

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The Peter Lynch chart also gives us an estimate of the intrinsic value of a stock, but this estimate is based more on earnings than on growth. As a result, this valuation tends to be more consistent than the Peter Lynch Fair Value, and a stock can be undervalued based on this metric even if it hasn’t been posting stellar growth numbers recently.

According to Lynch, the ideal time to buy a stock would be when its price dips below the earnings line. Studying the Peter Lynch chart for just about any stock reveals that in nearly every case, if you had bought a stock below its earnings line, there was a high likelihood of earning a positive return on the investment, given that its earnings line did not decline to below your initial purchase price due to the company’s struggles.

As with any valuation metric, the Peter Lynch chart can’t tell us how successful a company will be in the future. Purchasing shares of winners when they are trading below their earnings line or their median historical price-earnings line has a high likelihood of yielding good results, but purchasing shares of companies that fail in the future won’t turn out well even if they are trading at bargain prices.

The Peter Lynch chart can be found on the GuruFocus stock summary pages:

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As you can see, the chart is shown on a logarithmic scale by default. This is because the same change in price will represent a higher percentage if it occurs when the price is lower. For example, if the price increases $5 from $10 per share to $15 per share, it represents growth of 50%, while if the price increases that same $5 from $20 per share to $25 per share, it represents growth of 25%. Since the 50% growth is more significant than the 25% growth, the logarithmic scale helps put this in perspective by clearly showing orders of magnitude. Users can also choose to display the linear Peter Lynch chart if they wish.

Disclosures

I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The views of this author are solely their own opinion and are not endorsed or guaranteed by GuruFocus.com
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