Some of us have heard or learned about Peter Lynch’s PEG valuation formula but many of us probably took the formula at face value, at least that was what I was told when I was taught the formula. To recap for all, Peter Lynch is a famous fund manager and author of One Up on Wall Street and he proposed the PEG valuation model, especially for growth companies. The formula relates to a company’s PE ratio and its growth rate and is computed by taking the PE ratio divided by the company’s EPS (earnings per share) growth rate:
PE ratio / Growth Rate
> 1 implies overvalued
< 1 implies undervalued
Do you use the PEG formula as a valuation method? Is there a mathematical proof of the formula? Well, we will relate this to another valuation model which many of us are familiar with as well, the discounted cash-flow (DCF) model. Here, instead of using cash-flow, I will use EPS instead.
Let’s compute the intrinsic value of a company growing at various rates, from 10% to 25%. I am going to assume the company continues this good growth range for the next 10 years to derive the growth value and the terminal value is computed by discounting for a further 10 years of 4% growth rate. In addition, we take the discount rate as 15% and assume the initial EPS is $1. [Note: some people would suggest that you compute the company’s Weighted Average Cost of Capital WACC for the discount rate but really, save your time and use your expected rate of return for this figure]
It turns out that Peter Lynch’s formula is a good proxy to the DCF model. If a company is growing at 20% and the PE ratio is 20, it is about fairly valued. If the company is growing at 15% and the PE ratio is 15, it is about fairly valued. And so on.
In this illustration, we have not factored in Margin of Safety (MOS) which is prudent to include. The discount rate of 15% is used in this calculation; it should be noted however that the discount rate should be related to the market interest rate environment, which is relatively low now. If a lower discount rate of say 12% is used, the PEG formula may seem conservative.
I love the PEG formula as a very quick and easy filter for me to do a first cut valuation of any particular growth stock, whether I should put it in my watch list or some immediate investment decision may be made. I will then switch over to the DCF model as it provides me the flexibility of changing the various parameters to assess best case and worst case scenarios and the risk-reward ratios.
I hope that you know now that there is a basis to Peter Lynch PEG formula! It is still relevant to use but do take note of the interest rate environment we are in, whether the formula may be too conservative or not.
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