Peter Lynch’s Formulas for Valuing a Stock’s Growth

Why are we discussing Peter Lynch all of a sudden? Well, Peter Lynch is an American investor and a Mutual Fund Manager. As the Magellan Fund manager at Fidelity Investments between 1977 and 1990, Lynch averaged a 29.2% annual return, consistently more than double the S&P 500 stock market index and making it the best-performing mutual fund in the world. During his 13-year tenure, assets under management increased from US$18 million to $14 billion.

Source: Wikipedia

I hope that last line got you hooked, taking 18 million dollars and turning it into 14 billion dollars. Yes, that’s a billion with “B,” and there is no typo.

Now that you’re aware that we are talking about one of the legendary investors and fund managers, it is important to discuss his investment philosophy. Although we won’t cover every one of his investment philosophies, but we will divulge into one of my favorites. 

In his book “One Up on Wall Street” (If you haven’t read this masterpiece, then I highly recommended you do so), Lynch gives a straightforward explanation about one of his go-to metrics for valuing a stock:

The P/E ratio of any company that’s fairly priced will equal its growth rate. If the P/E of Coca-Cola is 15, you’d expect the company to be growing at about 15 percent a year, etc. But if the P/E ratio is less than the growth rate, you may have found yourself a bargain. A company, say, with a growth rate of 12 percent a year and a P/E ratio of 6 is a very attractive prospect. On the other hand, a company with a growth rate of 6 percent a year and a P/E ratio of 12 is an unattractive prospect headed for a comedown. In general, a P/E ratio that’s half the growth rate is very positive, and one that’s twice the growth rate is very negative.

Source: One Up on Wall Street

Let’s Understand this in our simple language:

The price-earning ratio (P/E ratio) is the ratio of a company’s share price to its earnings per share. P/E ratio is used for valuing companies to find out whether they are overvalued or undervalued. For example, a share trading at a P/E ratio of 10, is trading at 10X it’s annual earning.

Later, Lynch goes on to offer a different approach to the same basic concept:

“A slightly more complicated formula enables us to compare growth rates to earnings while also taking the dividends into account. Find the long-term growth rate (say, Company X’s is 12 percent), add the dividend yield (Company X pays 3 percent), and divide by the p/e ratio (Company X’s is 10). 12 plus 3 divided by 10 is 1.5.”

“Less than a 1 is poor, and a 1.5 is okay, but what you’re really looking for is a 2 or better. A company with a 15 percent growth rate, a 3 percent dividend, and a p/e of 6 would have a fabulous 3.”

Source: One Up on Wall Street

The P/E Ratio vs. The PEG Ratio vs. The Dividend Adjusted PEG Ratio

What does all of this mean? Well, later in his book, Lynch introduced his reader to two new concepts that he developed for measuring a company’s valuation and performance, the PEG ratio and the Dividend-Adjusted PEG ratio. These two new metrics are only a variation of the standard P/E ratio, but they offer a deep insight into company performance.

Price/Earnings to Growth (PEG) Ratio:

P/E ratio is a great metric for shortlisting stocks, but it has its shortcoming. The biggest limitation is that the P/E ratio tells nothing about the company’s growth. Let’s say two companies have a P/E ratio of 10, how will you differentiate among them? Well, the P/E ratio doesn’t tell us anything about the company’s performance. On its own, it’s not very helpful because if a company has no growth and earnings stayed the same, then your investments would not yield good returns.

Now what Lynch did to solve the shortcoming of the P/E ratio is to factor in the projected growth rate of future earnings. So now, if two companies are trading at 10x their earnings, and one of them is growing at 5% but the other at 10%, then you can identify the latter as a better bargain that will most likely make you more money.

The formula is: PEG ratio = P/E ratio / company’s earnings growth rate

If the result of the PEG ratio is one or lower than that stock is at par or undervalued based on its growth rate. If the result is greater than one, then the stock is overvalued relative to its growth rate.

Many investors believe the PEG ratio gives a more complete picture of a company’s value than a P/E ratio does.

The Dividend-Adjusted PEG Ratio:

Going even further, lynch developed another ratio called the dividend-adjusted PEG ratio. The problem with the PEG ratio was that it didn’t factor in the company’s dividends, which make up a big part of the total return of most of the blue-chip stocks. So the Dividend-Adjusted PEG Ratio is a modified version of the PEG ratio that accounts for dividend income.

Reinvested Dividends, especially during the Stock market crash, can create a “return accelerator,” drastically shortening the time it takes to recover losses. If you buy a stock at 20x earnings that are growing at only 7%, it may look expensive. However, if it distributes a sustainable 10% dividend, that’s clearly a much better deal.

The formula is: Dividend-adjusted PEG ratio = P/E ratio / (earnings growth + dividend yield)

Example: 

Let’s say you invested in a company ABC, which is currently trading at 100 Rs per share. Its earnings were 12 Rs per share over the past year. This is how you can calculate the stock P/E ratio:

ABC P/E ratio: 100/12 = 8.3

Now let’s say you find that the company ABC is projected to grow its earnings by 7% over the next three years. You can read the annual reports of the company to find the projected growth. This is how you can calculate PEG ratio:

ABC PEG ratio: 8.3/7 = 1.18

Finally, let’s factor in the ABC dividend yield of 3.2% and calculate the dividend-adjusted PEG ratio:

ABC dividend-adjusted PEG ratio: 8.3 / ( 7 + 3.2) = 0.81

When comparing the results, you should see that, after adjusting for dividends, ABC’s stock is cheaper than you might think.

Here are some of the stocks who offer good dividend yields.

Happening’s Around the Stock Market (24-05-2021)

NSE halts all trading on technical glitch:

  • Sebi has asked for a detailed report from NSE on shutdown over a tech glitch.
  • Rupee surges 11 paise to close at 72.35 against US dollar.
  • Sebi moots introduction of accredited investor concept.
  • D-Street experts feel the same way about bitcoin as our legendary investor Rakesh Jhunjhunwala.

Stock in News (24-05-2021)

  • Sanofi India board has approved a final dividend of Rs 125 per share and a special dividend of Rs 240 per share.
  • US FPA denies application from SPARC for cancer drug Taclantis.
  • Heranba Industries IPO subscribed 84% on day 1. Heranba Industries shares are available in a price band of Rs 626-627 per share.
  • Alkem Labs received US FDA nod for generic of antibiotic drugs Omnicef and Suprax.
  • Mazagon Dock signed MoU with Mumbai Port Trust.
  • Tata Power raises Rs 900 crore via non-convertible debentures (NCDs).
  • SBI Card raises Rs 550 crore through bonds.
  • Gujart issue closure notice to the UPL Jhagadia plant saying that operating the plant is a safety risk.
  • RailTel Corporation of India finalised the allotment of its IPO. Check your status here.
  • Pfize COVID-19 vaccine has received full approval from Brazil’s health regulatory agency.
  • NTPC inks pact to buy GAIL’s 25.51% stake in Ratnagiri Gas and Power Pvt Ltd (RGPPL).
  • Coal India board to consider the second interim dividend for FY21.

Finally, want to read an interesting article about Tesla and Bitcoin, well here it is: Bubbles, bubbles bound for trouble?

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