Peter Lynch's Secret Formula for Valuing a Stock's Growth
Arguably the greatest mutual fund manager in history, Peter Lynch's
astounding record at the helm of the flagship Fidelity fund before
retiring has guaranteed him a permanent spot in the money management
hall of fame. You already know I'm a big fan of his portfolio question
you should ask yourself at the end of each year. Now, you can add
another to your collection of investing tips and tricks. In his book
One Up on Wall Street, Lynch gives a simple, straight-forward,
fantastic explanation as to how he does a quick and dirty valuation of
a firm's growth versus its stock price. Here's just a short quote
explaining how he does it; I hope it encourages you to go out and buy
the book. It's one investment you won't regret - I've got three copies
in my office.
"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 and 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."
The More Complicated Version of Peter Lynch's Formula"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."
