Finance

Peter Lynch’s checklist to see if you should shortlist a stock

Peter Lynch

Legendary American investor Peter Lynch has provided retail investors with a list of financial data to check to shortlist stocks which may offer value.

Lynch is well-known for managing the Fidelity Magellan Fund, which averaged a 29.2% annual return and achieved the best 20-year return of any mutual fund ever.

Under his tenure, the fund increased assets under management from US$18 million to $14 billion.

To help retail investors make informed investment decisions, Lynch published three books – One Up on Wall Street, Beating the Street, and Learn to Earn.

As part of his advice to investors, he provided criteria for initial consideration for stocks that may be worth buying.

Maria Crawford Scott, the former editor of the American Association of Individual Investors (AAII) Journal, summarised Lynch’s criteria for initial consideration.

An important starting point is selecting shares from industries and companies you know and understand.

You should be able to list the factors that will move the share price and articulate the company’s growth plans. Investors should also know what risks a company face.

When an investor is happy that the company has a good story and is poised for growth, they should research what a fair price is.

Even if the company has a great story, it is difficult to make a profit if you pay too much for a share.

Lynch proposed the metrics below to determine a reasonable price for a share.

  • Year-by-year earnings – Look for stability and consistency and an upward trend.
  • P/E relative to historical average – The price-earnings ratio should be lower than its historical average.
  • P/E relative to industry average – The price-earnings ratio should be below the industry average.
  • P/E relative to earnings growth rate – A price-earnings ratio of half the level of historical earnings growth is attractive, while relative ratios above 2.0 are unattractive.
  • Debt-equity ratio – The company’s balance sheet should be strong, with low debt levels relative to equity financing. Be particularly wary of high levels of bank debt.
  • Net cash per share – The net cash per share relative to the share price should be high.
  • Dividends and payout ratio – For investors seeking dividend-paying firms, look for a low payout ratio and long records – 20 to 30 years – of regularly raising dividends.
  • Inventories – Inventories piling up are a warning flag, particularly if growing faster than sales.

Lynch advised this approach to create a list of shares to assess further, which may offer a buying opportunity.

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