In this blog post, we are going to show you how you can use Peter Lynch’s fair value model to value a stock. You will also be given access to a free Google Sheet calculator to use for your own stock analysis.
How Peter Lynch’s Fair Value Model Calculator Works
Peter Lynch’s fair value model, also known as the “P/E-to-Growth” ratio or the “Lynch Ratio,” is a valuation method that he used to assess the attractiveness of a stock. The model compares a company’s price-to-earnings (P/E) ratio to its projected earnings growth rate.
According to Lynch, the fair value of a stock can be determined by multiplying the P/E ratio by the company’s projected earnings growth rate. The formula is as follows:
Fair Value = P/E Ratio x Earnings Growth Rate
Lynch believed that the P/E ratio should not be higher than the company’s earnings growth rate. In other words, a stock with a P/E ratio lower than its earnings growth rate is considered undervalued, while a stock with a P/E ratio higher than its earnings growth rate may be overvalued.
For our calculator we slightly tweak Lynch’s formula to enable us to estimate the share price of a company: Fair Value = PEG x Earnings Growth Rate x EPS TTM.
Inputs to the calculation
Now lets look a bit close at what inputs you will need to complete this calculation.
P/E Ratio: The price-to-earnings ratio is a metric that compares a company’s stock price to its earnings per share. It is calculated by dividing the market price per share of a company by its earnings per share. Our calculator uses the Google Finance database to automatically pull this data.
EPS TTM (Trailing Twelve Months): EPS stands for Earnings Per Share. It is a financial metric that represents the portion of a company’s profit allocated to each outstanding share of common stock. EPS is calculated by dividing the company’s net income by the average number of outstanding shares during a specific period. For this calculation, we just want the latest data possible, so it is best to use the Trailing Twelve Months EPS which is available on Yahoo Finance.
Expected EPS Growth Rate: This is an estimation of the future growth of the Earnings Per Share. This can be taken from Yahoo Finance, which provide estimates of the for the future growth over the next 5 years (per annum).
PEG Ratio: equals the P/E Ratio / Earnings Growth Rate.
5 Year EBITDA Growth Rate: This is the average annual compounded growth rate of EBITDA over the past 5 years.
Weaknesses of Peter Lynch’s Valuation Model
If you were to be critical of Lynch’s valuation model, many would say it is an oversimplified way of trying value a company as it only pays attention to the P/E ratio and earnings growth rate.
Whereas, in reality there are many other vitally important business indicators that should be taken into account when valuing a company such as; the companies Free Cash Flows, Gearing, Cost of Equity, and Cost of Debt.
The fair value model also assumes that the market efficiently prices stocks based on their growth prospects, which we know is a shaky assumption.
Alternative Valuation Models
Of course it is never a good idea to base your financial decisions based on the results of one valuation model (or even many), as there are many other important factors that contribute to whether a company is a potentially good investment or not.
Some other popular valuation models that you could use to aid your stock analysis are the Discounted Cash Flow model and Gordon’s Growth Model.
All of these valuation models involve making a certain amount of assumptions, meaning if two people go try to calculate the fair value of the same stock using the same calculator, more often than not they will end up with different answers.
Who is Peter Lynch?
Lynch came to notoriety because of his work as the manager of the Fidelity Magellan Fund from 1977 to 1990. During his time with the fund, he generated outlandish returns, averaging an annualised growth rate of 29.2%, consistently outperforming the S&P 500 Index.
Disclaimer: This blog post is for informational and educational purpose only and should not be construed as financial advice.