Monday, October 08, 2012

Apple at $1000 a Share

Legendary mutual fund manager Peter Lynch made his fame by generating outsized returns investing in growth companies. He is willing to pay up for faster growing companies. He famously said that he would rather pay a P/E of 20 for companies that grow 20% than P/E of 10 for companies that grow at 10% a year. This comes to the concept that we call “Peter Lynch Fair Value” in our valuation box. In determining the fair value of the companies, Peter Lynch used a rule of thumb which says that the fair P/E of growth companies is equal to its earnings growth rate, that is, He is willing to buy a growth company at a P/E multiple that is equal to its growth rate. Therefore, to Peter Lynch, at fair value, the PEG ratio of a growth company should be 1.

Because of this, the calculation of Peter Lynch Fair Value is very straightforward. It simply equals to the growth rate multiplied by its earnings. That is:

Peter Lynch Fair Value = Earnings Growth Rate * Earnings.

Therefore, if a company grows its earnings 20% a year, to Peter Lynch, its fair valuation is 20 times its earnings.

Now how much is Peter Lynch willing to pay for Apple (AAPL) shares?

Apple has been able to grow its earnings per share at more than 60% a year, which is the result of tremendous revenue growth and margin expansion:

Apple earned more than $40 a share for the trailing twelve months. If Apple is worth a P/E of its growth rate of 60, the stock would be worth more than $2400 a share. Of course, Peter Lynch would only be willing to pay a P/E of 20 for the companies that grow faster than 20% a year. In this case, Apple shares would be worth about $1000 a share to Peter Lynch. Apple is now traded at around $660 a share, suggesting a 33% discount to Peter Lynch.

The historical Peter Lynch fair value for Apple stock is below:

Apple stock has been always traded at a discount compared with this fair value, but it did follow the trend in this chart. We don’t know if Peter Lynch owns Apple in his personal portfolio, but Apple is indeed a popular stock among the hedge fund Gurus we track. Owning this stock has definitely been rewarding.

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