Peter Lynch’s tool for finding stock bargains

One of the basic value metrics in the investor’s toolbox is the simple price-earnings (PE) ratio, but when we try to compare companies in the same industry or just want to get a handle on the value of a stock, it can still be a little unclear to tell when a bargain really is a bargain.

Most investors will be familiar with what it represents, but the PE ratio tells us how many times a company’s earnings per share we have to pay to buy a share of its stock. Thus, buying a share in Santos (ASX: STO) at $14.58 means I am paying 32.3 times its latest earnings per share.

Is that good, or is it pricey? You could look at other energy companies to get a comparative feel for the value, but how can you compare a multi-billion dollar company to say Senex Energy (ASX: SXY), which has a market capitalisation of $858 million and a PE of 13.5?

Peter Lynch, the well-known fund manager at Fidelity Investments who had a stellar run of investing in up and coming companies, and achieving fantastic returns for customers, described how regular, everyday investors can use a few numbers to see if they may have a bargain on their hands.

You just need three things – the company PE ratio, its dividend yield and the long-term earnings growth rate. Long-term should be about 10 years, but for a company that hasn’t been listed that long, the longer the better.

Looking at Brickworks (ASX: BKW), it has a PE of 20.5, a dividend yield of 2.91%, and a past 10-year NPAT (before abnormals) earnings compound annual growth rate of 3.24%. We add the dividend yield and earnings growth rate together like regular numbers to get  2.91 + 3.24 = 6.15.  Divide that by the PE of 20.5 and you get 0.30.

You want the final number to be 2 or more to be in real bargain territory, but 1.5 is ok. Below 1, and there is just not enough earnings growth and dividend return to balance out the high PE. That’s not to say that Brickworks isn’t worth the price, but we are measuring how much of a bargain the share price is. Its share price has been rising since August 2012 due to the housing market upturn, so the market is already pushing up the price in expectation of higher future earnings.

You may find your best bargains in industries that are out of favour currently. Earnings expectations are low and market conditions may be hard. Yet there may be a strong company out there that has taken a hit harder than need be.

David Jones (ASX: DJS), the department store company, was almost up to $6 a share in 2009, but in 2012 it was less than $2.50 and is $2.99 now. Is it a bargain now? It has a dividend yield of 5.69% and the 10-year past NPAT (before abnormals) earnings compound annual growth rate is 8.34%, and its PE is 16.7.

So add the first two, 5.69 + 8.34 = 14.03 and divide that by the PE of 16.7. You get 0.84. So even though the price has come down, the long-term earnings growth isn’t high enough to call it a bargain.

Salary packaging and integrated vehicle fleet services company McMillan Shakespeare (ASX: MMS) got caught up by the previous Labor government’s proposal to change fringe benefit tax calculations. Thereby causing a sudden reduction in the amount of vehicle leasing it did with salary packaging.

The share price fell from $18 to $8 over a very short time in July. It has only recovered to $11.58 now, even though the proposed legislation was scrapped before implementation.

Is it a bargain, what with its long-term high earnings growth?  Its dividend yield is 3.63%, and its past 8-year NPAT (before abnormals) compound annual growth is 36.8%. PE is 14.4.

Add 3.63 to 36.8 to get 40.43 and divide that by 14.4 to end up with a 2.81. That’s bargain territory. The company may not increase earnings by 36.8% every year in the future, but the past strong earnings growth history is the sign of a sound, growing business model. If you were quick enough to buy it at $8 a share, even better.

Foolish takeaway

Just like the PE ratio itself, the formula is a general standard of stock value, but wouldn’t be the only thing to base your investment decision upon.

Unlike the formula, the market looks at short-term earnings growth. So one year could have earnings down and the price reacts appropriately. But investors concentrating on companies with long-term strong earnings growth, will pick-up valuable buy signals.

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Motley Fool contributor Darryl Daté-Shappard does not own shares in any company mentioned. 

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