# Behind the numbers: Peter Lync

The GuruFocus site brings together a wide variety of information and calculations that investors can use to determine whether or not investing in a specific stock is the right choice for them.

Among these measures, two come from Peter Lynch, the very successful manager of the Magellan Fund which obtained an average annual return of 29.2% between 1977 and 1990. It is the Peter Lynch Fair Value, created on the basis of the idea that the fair price-earnings ratio for a growing firm equals its growth rate; and Peter Lynch’s chart, which compares a firm’s price line to its profit line.

**Peter Lynch fair value**

Peter Lynch fair value is a valuation method intended to be applied to growing companies, the ideal growth rate being between 10% and 20%. This valuation method assumes that the price / earnings ratio of a growing company is equal to its growth rate, i.e. its PEG ratio is 1.

The Peter Lynch fair value is calculated as follows:

“Peter Lynch fair value = PEG ratio * EBITDA growth rate over 5 years * EPS without NRI (TTM)”

For non-bank companies, the growth rate used by GuruFocus is the average growth rate of EBITDA per share over the past five years. Instead, for banks, GuruFocus uses the average growth rate of book value per share over the past five years. The five-year growth rate is capped at 25% per year, and if it is less than 5% per year, the Peter Lynch Fair Value is not calculated.

**Peter Lynch’s graphic**

The Peter Lynch chart is sometimes confused with the Peter Lynch Fair Value, but they are two entirely separate valuation methods.

Describing what would later become Peter Lynch’s graphic on pages 164 and 165 of his book “One Up on Wall Street,” Lynch wrote:

“A quick way to tell if a stock is overvalued is to compare the price line to the profit line. If you bought familiar growth companies – such as Shoney’s, The Limited, or Marriott – when the stock price fell well below the profit line, and sold them when the stock price has risen significantly above it, there’s a good chance you’ll be doing pretty well. “

GuruFocus’s Peter Lynch chart compares the stock’s price line to two hypothetical lines: the first is what the stock’s price would be if it traded with a price-to-earnings ratio of 15 (which Lynch dubbed the which would be the stock price if it traded at its median price-to-earnings ratio with no one-time items of the past decade.

**Uses and pitfalls**

The Peter Lynch Fair Value gives us an estimate of the intrinsic value of a growth stock. This can be useful in identifying growth stocks that are trading at a low price relative to their growth value, provided that this growth continues in the years to come.

So, if a company’s business is expected to grow at a faster rate than in the past, investors who have done their due diligence on the business might still find a good stock. market although she is trading above her Peter Lynch. Just value. However, such growth is rare, so in most cases if a stock is trading above this valuation estimate, it means that future returns will depend on investors continuing to pay high multiples for the stock.

One of the downsides of this method is that it is not useful for pillars that pay dividends and are growing at a growth rate of less than 5%. Plus, if a company grows profits too quickly, Peter Lynch’s fair value cuts it down to 25% per year. This helps avoid the effects of one-off years or other mitigating circumstances, but some growth investors may dislike the threshold and may choose to eliminate it in their own fair value calculations.

To compare a stock’s price to its fair value Peter Lynch, GuruFocus users can select these two lines on a stock’s interactive chart:

On the stock summary pages, the price / Peter-Lynch-Fair-Value ratio is shown in the “valuation and performance” section:

The Peter Lynch chart also gives us an estimate of the intrinsic value of a stock, but that estimate is based more on earnings than growth. As a result, this valuation tends to be more consistent than the Peter Lynch fair value, and a stock may be undervalued based on this metric even if it has not experienced rapid growth recently.

According to Lynch, the perfect time to buy a stock would be when its price drops below the profit line. Studying the Peter Lynch chart for just about any stock reveals that in almost all cases, if you bought a stock below its profit line, there was a high probability of earning a return on your investment. positive, given that its profit line has not declined. below your original purchase price due to business difficulties.

As with any valuation metric, the Peter Lynch chart cannot tell us how successful a business will be in the future. Buying stocks of winners when they are trading below their profit line or historical median price-earnings line has a high probability of doing well, but buying stocks of companies that will fail in the future will not turn out well even if they trade at cut prices.

The Peter Lynch chart can be found on the GuruFocus action summary pages:

As you can see, the graph is displayed on a logarithmic scale by default. This is because the same price change will represent a higher percentage if it occurs when the price is lower. For example, if the price increases from $ 5 from $ 10 per share to $ 15 per share, this represents a growth of 50%, while if the price increases from $ 5 from $ 20 per share to $ 25 per share, that represents a growth of 25%. Since 50% growth is more important than 25% growth, the logarithmic scale helps put this in perspective by clearly showing the orders of magnitude. Users can also choose to view Peter Lynch’s line graph if they wish.