Peter Lynch was an American fund manager who, between 1977 and 1990, achieved an average yearly return of 29.2% from the Magellan Fund. His fund posted the best 20-year return of any fund, ever. He started with $18 million and left it with more than $14 billion under management. The fund had 1,000 stock positions.
If you're a seasoned investor and haven't read one of Lynch's books by now, stop everything and do it now. His insights, style of investing and life lessons are easy to understand yet applicable to any investor's strategy.
Lynch's famous invest in what you know strategy helped him to find rapidly growing companies before analysts on Wall Street began to cover the stock. However he didn't blindly buy everything he saw (yes I know, he did have 1,000 stocks).
One of the simplest valuation techniques popularised by Lynch was the use of a PEG ratio. The PEG, or price earnings to growth ratio, takes a company's current and forecast earnings per share to get its expected profit growth, as a percentage.
A company's current earnings per share can be derived by dividing annual profits by the number of shares outstanding. Future earnings can be modelled by you, or alternatively you can use analysts' forecasts.
So would Lynch buy Westpac?
Everyone reading this article will know Westpac Banking Corp (ASX: WBC) and have likely used its services. It would have come across Lynch's desk many times.
However, that's as far as it would go today. According to Morningstar's analysts' consensus forecasts, Westpac's earnings per share are forecast to hit $2.41 when it reports its FY14 results later in the year. Based on its current earnings per share of $2.24 and P/E ratio of 15, it has a PEG ratio of 2.
Lynch believed a PEG ratio of 1 could indicate fair value whilst anything higher than that indicated a possible overvaluation. According to his ratio, Westpac is overvalued.
What about other valuation techniques?
Lynch's formula was simple. Perhaps too simple. That's why it shouldn't be used in isolation. However investors can combine it with other valuation techniques to get a better picture of the company.
For example, Westpac currently trades on a P/B ratio of 2.3 (excessive), dividend yield of 5.2% and is within $2 of its all-time high. In addition, analysts are painting an even gloomier picture of Westpac's (and all the big banks) earnings in coming years. Morningstar's forecasts suggest earnings will rise by less than 10% over the next four years.
To buy, or not?
At its high current share price, with profits tipped to grow slower than ever, Westpac is far from a buy. In fact, I believe it is a clear 'Sell'.
