Peter Lynch Fair Value
Peter Lynch is one of the most successful investors and mutual fund managers. His methods of selecting stocks are unique and simple. He invented his own method to value stock which is now known as Peter Lynch Fair Value. It is computed by multiplying PEG, EPS TTM, and Earnings Growth Rate. This metric shows whether the company is currently trading at its fair value or not.
The formula to derive Peter Lynch Fair Value
Note: We use EBITDA (5-Year CAGR) for non-banking companies and the average growth rate of BVPS (Book Value Per Share) for banking instead of Earnings Growth Rate.
Example: Aurobindo Pharma Ltd. reported EPS TTM as 49.05 and EBITDA (5Y CAGR) is 20.41%.
The value as per the formula ( Peg x EBITDA (5Y CAGR) X EPS TTM) is calculated as (1 x 49.05 x 20.41) = 1001.11.
Aurobindo Pharma Limited is currently trading at a lower price than Peter Lynch Fair Value. So as Peter Lynch Fair value indicates that it is undervalued.
Interpretation
In Peter Lynch fair value formula earning growth is considered as EBITDA (5-Year CAGR) for non-banking Companies, and for banking companies, it is considered as Book Value Per Share (5-year CAGR). The EBITDA growth rate is used because it is less subject to management manipulations and distortions. BVPS is considered for banks instead of EBITDA because book value is more important for banks. An ideal growth rate range is between 10%-20% a year. A company's growth rate over 25% is considered 25 when calculating Peter Lynch's fair value. And also, note that Peter Lynch's fair value is not applicable for companies with a growth rate lower than 5%.
According to Peter Lynch, a growth company's P/E should equal its growth rate, so the PEG should equal 1.
Price to Peter Lynch Value:
Price to Peter Lynch value is a version of his fair value method that compares the company's current stock price with its peter lynch fair value. It indicates the fair value of the stock and whether the company is undervalued or overvalued. It is calculated by dividing the current stock price by Peter Lynch Fair Value.
The formula to derive Price to Peter Lynch Fair Value
Example: As shown above, Peter Lynch Fair Value of Aurobindo Pharma Limited is 1001.11, and its current stock price is Rs. 657. The value as per the formula (Current Price / Peter Lynch Fair Value) is calculated as (657 / 1001.11) = 0.66.
Formula Content
• PEG Ratio-
PEG Ratio indicates the relationship between stock price and Earnings Per Share (EPS) growth rate. It is useful to evaluate whether the stock is undervalued or overvalued. Generally, the PEG ratio below one is considered good as it indicates the stock is undervalued. It is computed by dividing PE Ratio by EPS growth rate. The PEG ratio is an abbreviation for Price-Earnings to Growth Ratio. It was invented by Mario Farina and published in 1969 in his book "A Beginners Guide To Successful Investment In The Stock Market."
• EBITDA (5Y CAGR) -
The EBITDA 5-Year CAGR represents the company's five-year compounded annual growth rate of EBITDA. CAGR is an abbreviation for Compound Annual Growth rate, and it measures the returns for anything that can rise or fall in value over time. EBITDA is earnings before interest, taxes, depreciation, and amortization is found in the company's Income Statement.
• EPS (TTM)-
EPS TTM is the abbreviation for Earnings Per Share Trailing Twelve Months. Earnings Per Share (EPS) TTM Ratio is a valuation metric that measures how much money a company makes on a per share basis. EPS is calculated as net income divided by weighted share outstandings. This metric indicates the company's ability to generate net profits for common shareholders.
• Current Price -
It is the most recent selling price of stocks. The current price indicates the current value of the stocks, and it is also known as market value.
History
Peter Lynch was an American investor, mutual fund manager, and philanthropist. He graduated from Boston College in 1965 and had studied history, psychology, and philosophy. His first successful investment was an Air-freight company called Flying Tiger which helped him to pay for graduation. At age 25, he got his first full-time job in the textile, metal, mining, and chemicals industries as an analyst at fidelity. Later in 1968, Peter Lynch completed a Master of Business Administration from the Wharton School of the University of Pennsylvania. He has written three books on investing with co-author John Rothchild: One Up on Wall Street, Beating the Market, and Learn to Earn. The Learn to Earn book was written for new investors of all ages. In One Up on Wall Street, he explains his investment techniques, including chapters devoted to classification, the two-minute drill, famous numbers, and designing a portfolio. From 1977 to 1990, he managed the Magellan Fund, which averaged a 29.2% return under his leadership.
Narrative
Peter Lynch explains the p/e ratio and growth rate in his book One up on Wall Street:
As a rule of thumb: Peter Lynch says he is willing to invest in the stock of a growing company whose P/E multiple is equal to its growth rate. A company with a P/E ratio of 15, you would expect the company to grow at around 15 percent per year. An attractive company is one with a growth rate of 12% a year and a P/E ratio of 6. On the other hand, if the company has a p/e ratio of 12, and its growth rate is 6%, then it is an unattractive prospect and headed for the comedown. In simple terms, if the p/e ratio of the company is half of the growth rate is very positive.
How to Use Peter Lynch Fair Value
Peter Lynch Fair Value indicates whether the stock is trading at fair value or not. In other words, it shows whether the company's stock is undervalued or overvalued. If the stock is trading at a high price compared to the Peter Lynch Fair Value, then it indicates that it is overvalued. Contrary to this, if the company's stock is trading at a low price compared to the Peter Lynch value, then it is undervalued. While calculating Peter Lynch Fair Value we considered the PEG ratio as 1.
Conclusion
While looking at Peter Lynch Fair Value investors should look for companies that are trading at a low price compared to Peter Lynch Fair Value. Stocks of companies that trade at a higher price than a Peter Lynch Value are considered overvalued.
