Peter Lynch's Secret Formula for Valuing a Stock's Growth

The Standard & Poor's 500 index includes 500 leading American companies listed on the NYSE or NASDAQ and captures 80% coverage of available market capitalization.

■ Ticker symbols: $SPX | ^GSPC | INX

The S&P 500 stock market index is based on the market capitalizations of 500 large American companies having common stock. S&P 500, introduced in 1923, as the ‘Composite Index’. On March 4, 1957, it expanded to its current 500 stocks basket. Today, it is one of the most traded equity indices in the world. The S&P 500 differs from other U.S. stock market indices, because of its weighting methodology.

 

S&P500 Calculation and Weighting

The S&P 500 has traditionally been a capitalization-weighted index. Since 2005, the index has calculated the market capitalization of each company relevant to the S&P 500 using only the floating number of shares (shares available for public trading).

Table: Top 10 Shares by Index Weight in the S&P500

COMPANY	SYMBOL	INDUSTRY
Apple Inc.	AAPL	I.T.
Microsoft Corp	MSFT	I.T.
Amazon.com Inc	AMZN	Consumer
Facebook Inc A	FB	I.T.
Johnson & Johnson	JNJ	Health Care
Berkshire Hathaway B	BRK.B	Financial
JP Morgan Chase & Co	JPM	Financial
Exxon Mobil Corp	XOM	Energy
Alphabet Inc A	GOOGL	I.T.
Alphabet Inc C	GOOG	I.T.

Find the full list at Wikipedia: https://en.wikipedia.org/wiki/List_of_S%26P_500_companies

 

S&P500 Trading Hours Profitability

The best time to be invested in S&P500 is from the previous day's close to 10 a.m. (overnight positioning). The worst time to be invested in S&P500 is 10 a.m. to 11 a.m.

(↑) BEST TIMES GOING LONG :

(1) Previous Day’s close to 10 a.m. EST (or 3 p.m. GMT)

(2) From 3 p.m. to 4 p.m. EST (or from 9 p.m. to 10 p.m. GMT)

(↓) BEST TIMES GOING SHORT:

(1) 10 a.m. to 12 a.m. EST (or from 3 p.m. to 5 p.m. GMT)

Source: SeekingAlpha.com, @PavelShishigin

 

Applying the Peter Lynch's Formula to S&P500 (Median and Current Value)

In his book, One Up on Wall Street (1989), the famous mutual fund manager Peter Lynch provides a simple model of comparing corporate growth over stock-market price.

Here is how it works...

 

(1) Linking P/E to Growth Rates

In short, Lynch argues that any firm’s P/E ratio must equal its growth rate,

here is an example:

-If the P/E ratio of Company-X is 10 then you should expect its annual growth rate at 10%

-If the P/E ratio of Company-X is 35 then you should expect its annual growth rate at 35%

Lynch: "In general, a P/E ratio that's half the growth rate is very positive, and one that's twice the growth rate is very negative."

 

(2) Linking Dividend Yields to P/E and Growth Rates

Lynch goes a step further to this interesting concept by adding dividend yields.

Lynch: "Find the long-term growth rate (say, Company X's is 12 percent), add the dividend yield (Company X pays 3 percent), and divide by the p/e ratio (Company X's is 10). 12 plus 3 divided by 10 is 1.5."

Here is what the Lynch Formula looks like:

(1) Take the long-term growth rate (for example, 10%)

(2) Add the dividend yield (for example, 2%)

(3) Divide by the P/E ratio (for example, 12)

In our example, (10+2)/12=1

Lynch: "Less than a 1 is poor, and a 1.5 is okay, but what you're really looking for is a 2 or better. A company with a 15 percent growth rate, a 3 percent dividend, and a p/e of 6 would have a fabulous 3."

 

(3) Applying the Formula to the Current S&P500 Price and Earnings (1871-2017 Median Value & Current Value)

Now we are going to apply the same concept to the S&P500 and compare the median value (1871-2017) to its current value.

• Median Period: 1/1/1871-11/14/2017
• Current Close: 11/14/2017
• Data Source: multpl.com

□ Current S&P 500 Earnings Growth Rate (2017/11/14): 16.02%

□ Median S&P 500 Earnings Growth Rate: 10.12%

□ Current S&P 500 Dividend Yield (2017/11/14): 1.87%

□ Median S&P 500 Dividend Yield: 4.31%

□ Current S&P 500 P/E Ratio (2017/11/14): 25.71

□ Median S&P 500 P/E Ratio: 14.67

 

Calculating the Median S&P500 Value

□ {(Median Growth Rate + Median Dividend Yield) / (Median P/E)} =

= {(10.12 + 4.31) / 14.67} =

= 0.984 (close to 1)

Calculating the Current S&P500 Value

□ {(Current Growth Rate + Current Dividend Yield) / (Current P/E)} =

= {(16.02 + 1.87) / 25.71} =

= 0.696 (significantly less than 1)

 

Conclusions

According to the Lynch formula, the S&P500 is indeed overvalued. To maintain the current levels, S&P500 needs considerably higher growth rates or considerably higher dividend yields, for the next few years.

 

Shiller PE Ratio for the S&P 500

Chart: S&P 500 and Shiller PE Ratio

Price-earnings ratio is based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio).

-Current Shiller PE Ratio: 32.33 (Nov 2017)

-Mean: 16.80

-Median: 16.15

-Min: 4.78 (Dec 1920)

-Max: 44.19 (Dec 1999)

Shiller PE Ratio, or PE 10. Data courtesy of Robert Shiller.

 

■ S&P500 and the Stock Market Formula

G.Protonotarios for TradingCenter.org

Sources: Wikipedia.org, Multpl.com, SeekingAlpha.com, Yale.edu