How to Value a Stock Like Peter Lynch

Fajasy
Updated: May 18, 2024

Contents

In this article, I will show you how to value a stock like Peter Lynch. This method assesses a stock's valuation by calculating the ratio of a company's expected future earnings per share (EPS) growth rate plus its dividend yield, divided by its price-to-earnings (P/E) ratio. This article will discuss the specifics of this valuation approach, explain how to interpret the results, provide a real-world example, and explore its limitations.

Peter Lynch's Stock Valuation Method Explained

Peter Lynch, the legendary investor and former manager of the Magellan Fund at Fidelity Investments, achieved an impressive average annual return of 29.2% during his tenure from 1977 to 1990. Lynch is renowned for his investment acumen and his ability to identify undervalued stocks, making him one of the most successful investors in history.

The Peter Lynch stock valuation approach, first introduced in his book "One Up On Wall Street" in 1989, is a method that determines whether a stock is fairly valued, overvalued, or undervalued based on its expected future earnings growth, dividend yield, and price-to-earnings (P/E) ratio.

This approach is rooted in Lynch's investment philosophy, which emphasizes understanding a company's fundamentals and growth prospects. By focusing on these key metrics, Lynch's method provides a straightforward way for investors to assess the intrinsic value of a stock and make informed investment decisions.

Peter Lynch's Fair Value Formula

The Peter Lynch fair value formula is shown below:

Peter Lynch's Fair Value = (Future EPS Growth Rate + Dividend Yield) / P/E Ratio

where:

  • Future EPS Growth Rate = Expected future growth rate of the company's earnings per share (EPS)
  • Dividend Yield = Annual Dividend Per Share (DPS) / Current Stock Price
  • P/E Ratio = Current Stock Price / EPS

The Peter Lynch fair value formula provides a straightforward method to assess a stock's valuation by considering its expected future earnings growth, dividend yield, and current P/E ratio.

The dividend yield and P/E ratio are based on the company's current financial data and stock price, which are readily available. The primary assumption in this formula is the future EPS growth rate, which investors must estimate based on their analysis of the company's growth prospects.

Peter Lynch's valuation method suggests that a stock is fairly valued when its P/E ratio aligns with its expected growth rate and dividend yield. Essentially, a Peter Lynch fair value close to 1.0 indicates fair valuation. This method holds because it reflects the price investors are willing to pay for future growth and current dividends.

For instance, a company with an expected EPS growth of 15% and a dividend yield of 3% would have a fair value of 1.0 if its P/E ratio is 18x ((15% + 3%) / 18x). If the P/E ratio were significantly higher than 18x, the stock would be considered overvalued, while a P/E ratio significantly lower than 18x would suggest undervaluation.

How to Interpret Peter Lynch's Fair Value Formula

Unlike most absolute valuation methods, the Peter Lynch fair value formula does not provide an intrinsic share price that you can directly compare to the company's current stock price to determine its valuation. Instead, the formula yields a ratio that indicates whether the stock is overvalued, fairly valued, or undervalued.

Here’s how Peter Lynch describes the interpretation of his formula's output in his book "One Up On Wall Street":

"Less than a 1 is poor, and 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."

- Peter Lynch in "One Up On Wall Street," pg. 189

The Peter Lynch fair value ratio can therefore be interpreted as follows:

  • Less Than 1.0: Overvalued, indicating poor value.
  • Around 1.5: Fairly valued, pricing aligns with financial performance.
  • Greater Than 2.0: Undervalued, suggesting strong value and a good investment opportunity.

For example, if a company has an expected EPS growth rate of 12%, a dividend yield of 3%, and a P/E ratio of 20x, the Peter Lynch fair value would be:

Peter Lynch Fair Value = (12% + 3%) / 20x --> 0.75

In this case, the ratio of 0.75 suggests that the stock is overvalued according to the Peter Lynch fair value formula.

On the other hand, if the same company had a P/E ratio of 10x, the Peter Lynch fair value would be:

Peter Lynch Fair Value = (12% + 3%) / 10x --> 1.5

A ratio of 1.5 indicates that the stock is fairly valued based on its expected growth rate and dividend yield.

It's important to remember that these interpretations are general guidelines and should not be considered strict rules. Always consider other valuation models and quantitative/qualitative factors before making investment decisions.

Peter Lynch's Fair Value Formula and the PEGY Ratio

The price-to-earnings to growth (PEG) ratio was originally developed by Mario Farina who wrote about it in his 1969 Book, "A Beginner's Guide To Successful Investing In The Stock Market." Peter Lynch later modified the PEG ratio to create the price-to-earnings to growth and dividend yield (PEGY) ratio.

Lynch observed that the P/E ratio had limitations when analyzing stocks because it did not account for potential future earnings growth or dividends. While the PEG ratio addressed the issue of growth by including expected earnings growth, it still did not consider dividends. As a result, companies that regularly paid dividends, especially those with lower growth rates common in mature companies, were not fairly evaluated using the P/E or PEG ratios alone.

To address these limitations, Lynch developed the PEGY ratio, which incorporates both projected earnings growth and dividend yield into the valuation metric.

Notably, the PEGY ratio is simply the inverse of the Peter Lynch fair value formula, as shown below:

PEGY Ratio = P/E Ratio / (Future EPS Growth Rate + Dividend Yield)

The PEGY ratio compares a company's P/E ratio to its expected EPS growth rate and dividend yield, and can be interpreted as follows:

  • PEGY Ratio < 1.0: Indicates that the P/E ratio is lower than the sum of the expected EPS growth rate and dividend yield, suggesting that the stock may be undervalued.
  • PEGY Ratio = 1.0: Indicates that the P/E ratio is equal to the sum of the expected EPS growth rate and dividend yield, suggesting that the stock is fairly valued.
  • PEGY Ratio > 1.0: Indicates that the P/E ratio is higher than the sum of the expected EPS growth rate and dividend yield, suggesting that the stock may be overvalued.

In short, the PEGY ratio and the Peter Lynch fair value formula are two sides of the same coin, providing investors with a quick way to assess whether a stock's valuation is justified by its expected EPS growth and dividend yield.

Peter Lynch's Stock Valuation Method Example

To demonstrate how to value stocks like Peter Lynch, we'll use Kinder Morgan (KMI) as our example company. Kinder Morgan is one of the largest energy infrastructure companies in North America, specializing in the ownership and management of pipelines and storage facilities for natural gas, gasoline, crude oil, and other fuels.

To calculate Peter Lynch's fair value formula, follow these steps:

  • Step #1: Estimate the Future EPS Growth Rate
  • Step #2: Calculate or Find the Dividend Yield
  • Step #3: Calculate or Find the Price-to-Earnings (P/E) Ratio
  • Step #4: Calculate and Interpret Peter Lynch's Fair Value Formula

Investors can use the Peter Lynch stock valuation spreadsheet linked below to follow along with the Kinder Morgan stock valuation example:

Step #1: Estimate the Future EPS Growth Rate

The future EPS growth rate is the expected annual growth rate of a company's earnings per share (EPS).

To estimate the expected annual growth rate of a company's EPS, you should consider various factors such as the company's historical growth, industry trends, competitive landscape, and management's guidance. While this estimate should be based on your personal understanding of the company, you can use historical data, analyst estimates, and company guidance to inform your decision.

In the case of Kinder Morgan, we'll evaluate its most recent historical data, management guidance, and analyst estimates to decide on a reasonable future EPS growth rate.

First, let's examine Kinder Morgan's basic EPS from 2014 to 2023, as visualized in the chart below:

As you can see, Kinder Morgan's basic EPS has been fairly volatile and has only improved by 1.6% over the 10-year compound annual growth (CAGR) period (from 2014 to 2023).

It's also worth examining the company's 2024 Q1 investor presentation slides, in which the company expects its FY 2024 EPS to grow 15.1% annually (from $1.06 to $1.22).

Lastly, we can examine the consensus analyst estimates on stock market data websites, like Yahoo Finance, to gauge how Wall Street is thinking about the company's growth:

| Stablebread
Source: Yahoo Finance

Thus, the consensus growth estimate for the next 5 years (per annum) is 5.30%.

Given the linear growth assumption in Peter Lynch's fair value formula, it's important to be conservative with our Kinder Morgan EPS growth rate assumption. Therefore, we'll use 3.0%, which appears to be a more conservative rate based on the presented data.

Step #2: Calculate or Find the Dividend Yield

The dividend yield is the annual dividend per share expressed as a percentage of the current stock price.

You can find the annual dividend per share (DPS) on the company's website, in the 10-K annual report, or on stock market data websites. You can also calculate the dividend yield using the following formula:

Dividend Yield = Annual Dividend Per Share (DPS) / Current Stock Price

For Kinder Morgan, it's annual DPS in FY 2023 is $1.13, and its current stock price is ~$19.70. The dividend yield would therefore be:

Dividend Yield [KMI; FY 2023] = $1.13 / $19.70 --> 5.71%

Thus, Kinder Morgan's current dividend yield is 5.71%, indicating that investors receive a 5.71% return on the current stock price in the form of dividends.

Step #3: Calculate or Find the Price-to-Earnings (P/E) Ratio

The price-to-earnings (P/E) ratio is a valuation metric that compares a company's stock price to its earnings per share (EPS).

You can find the P/E ratio on stock market data websites or calculate it using the following formula:

P/E Ratio = Current Stock Price / Earnings Per Share (EPS)

where:

  • Earnings Per Share (EPS) = Net Income / Weighted Averages Shares Outstanding

The company's EPS is typically at the bottom of the income statement or on stock market data websites. It can also be calculated from the net income and weighted average shares outstanding, both also listed on the income statement.

Here's Kinder Morgan's income statement, with these two items outlined. As you can see, the basic/diluted EPS is also directly provided:

| Stablebread
Source: Kinder Morgan (KMI) 10-K Annual Statement (Income Statement)

Thus, Kinder Morgan's FY 2023 basic/diluted EPS is $1.06, which can also be calculated as follows:

Basic/Diluted EPS [KMI; FY 2023] = $2,391M / 2,234M --> $1.06

Now, we calculate Kinder Morgan's current P/E ratio as follows:

P/E Ratio [KMI; FY 2023] = $19.70 / $1.06 --> 18.58x

Kinder Morgan's P/E ratio of 18.58x suggests that investors are willing to pay $18.58 for every $1 of the company's earnings.

Step #4: Calculate and Interpret Peter Lynch's Fair Value Formula

Now that we have all the inputs for Peter Lynch's fair value formula, we can calculate and interpret the figure for Kinder Morgan.

As a reminder, Peter Lynch's fair value formula is calculated by adding the future EPS growth rate to the dividend yield, then dividing the result by the P/E ratio, as shown below:

Peter Lynch Fair Value = (Future EPS Growth Rate + Dividend Yield) / P/E Ratio

If we plug in the values we found from the previous steps for Kinder Morgan, we can complete Peter Lynch's fair value formula:

Peter Lynch Fair Value [KMI; FY 2023] = (3.0% + 5.71%) / 18.58x --> 0.47

The fair value ratio of 0.47 suggests that Kinder Morgan's current stock price is overvalued (given that it's below 1.0), according to Peter Lynch's criteria discussed earlier. In other words, this means that the stock's current price is higher than what Peter Lynch's fair value formula suggests it should be, based on the company's expected growth rate, dividend yield, and current P/E ratio.

Limitations of the Peter Lynch Stock Valuation Method

Peter Lynch's fair value formula, while useful for quickly assessing stock valuations, has several limitations that investors should consider before using it as their sole valuation method. These drawbacks, affecting the formula's accuracy and effectiveness, should be carefully considered when applying Lynch's approach to investment decisions, as discussed below:

  • Reliance on Estimates: The formula heavily relies on the expected future EPS growth rate, which is an estimate and subject to error. Forecasting a company's future earnings growth is inherently challenging and requires a deep understanding of the company, its industry, and the broader economic environment.
  • Linear Growth Assumption: The formula assumes that a company's earnings growth will continue at a constant rate, which may not be realistic. Companies often experience fluctuations in growth rates over time due to various factors such as economic cycles, market saturation, and competition.
  • Simplistic Approach: The formula does not consider critical factors such as debt levels, cash flow generation, competitive advantages, and industry trends, which can affect a stock's value. This simplistic approach may not capture the full complexity of a company's financial situation, and a more comprehensive analysis is often necessary for informed investment decisions.
  • Limitations Compared to Absolute Valuation Methods: The Peter Lynch fair value method has limitations when compared to absolute valuation methods like the discounted cash flow (DCF). The Lynch method focuses on short-term growth projections, while DCF analysis involves projecting cash flows over a longer period. The compounding effect of the growth rate over an extended period in the DCF may therefore result in a higher intrinsic value estimate compared to the Lynch method. Regardless, the Lynch method can still provide insights into a company's current valuation relative to its recent performance.
  • Not Suitable for All Companies: The formula may not be appropriate for evaluating companies that don't pay dividends or have negative earnings, as it relies on dividend yield and positive earnings per share. This limitation can exclude a significant portion of the investment universe, particularly growth-oriented companies that reinvest their earnings.

In summary, while investors can use Peter Lynch's fair value formula as a stock valuation tool, combining this method with other valuation techniques, thorough research, and a well-founded hypothesis of a company's future prospects is recommended for a more informed investment decision-making process.

The Bottom Line

Peter Lynch's stock valuation method, introduced in his book "One Up on Wall Street," is a straightforward approach for assessing a stock's valuation. To calculate it, investors need to estimate the company's future earnings per share (EPS) growth rate, then find or calculate the company's current dividend yield and price-to-earnings (P/E) ratio.

The output of the Peter Lynch fair value formula is a ratio that can be interpreted as follows: less than 1 indicates the stock is overvalued, around 1.5 suggests the stock is fairly valued, and greater than 2 implies the stock is undervalued. This ratio can therefore be beneficial in quickly identifying investment opportunities or avoiding overpriced stocks.

However, because Peter Lynch's stock valuation method is simplistic, limited in scope, and not suitable for all companies, investors should also consider other stock valuation methods and perform additional research on the company's prospects before coming to investment decisions.

Disclaimer: Because the information presented here is based on my own personal opinion, knowledge, and experience, it should not be considered professional finance, investment, or tax advice. The ideas and strategies that I provide should never be used without first assessing your own personal/financial situation, or without consulting a financial and/or tax professional.

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