Peter Lynch’s Preferred Valuation Metric Identifies the Most Affordable “Magnificent Seven” Stock

We talked a lot about “Magnificent Seven” recently. These large, competitively advantageous technology platforms have significantly outperformed the market over the past decade, and they also appear to be good bets to benefit from the artificial intelligence revolution.

But their recent strong run has led many to believe that these stocks are either overvalued or reasonably priced relative to the rest of the market. On the other hand, many have been saying it for years, only to watch these tech giants beat profit expectations.

How can their relatively high stock market valuations and their above-average growth prospects be reconciled? A valuation metric touted by one of the most famous mutual fund managers of all time might just hold the secret.

The PEG ratio

The PEG ratio, or price/earnings/growth measure, was first developed in 1969 by Mario Farina, then popularized by Peter Lynch, portfolio manager of the Fidelity Magellan Fund in the 1980s.

To calculate the PEG ratio, an investor must divide a company’s P/E ratio by its expected earnings growth rate. In general, stocks can have a PEG ratio between 1 and 2, with stocks with a PEG below 1 considered undervalued and stocks above 2 considered overvalued.

A PEG ratio is admittedly an imperfect measure, as some investors may use the current or forward P/E ratio, and others use different time frames to calculate long-term earnings growth numbers.

A standard type of PEG ratio involves looking at the P/E ratio based on expected earnings for the current year and earnings growth prospects for the next five years.

Magnificent PEG ratios

Here’s how the PEG ratios of Magnificent Seven stocks are trending.

Data source: Yahoo! Finance.

The story continues

There are some expected results here, but also some surprises. First, it’s not surprising to see Meta and Alphabet among the cheapest stocks. These two companies typically trade at a discount to other “disruptive” tech names, perhaps because they are already large, “mature” companies. Additionally, many investors place less credit on revenue and profits from advertising because these are considered economically sensitive and perhaps volatile.

Yet that’s been the case for years, and Alphabet and Meta have generally managed to defy the skeptics and continue solid growth over the long term, as ad dollars continue to flow to digital ads from ads traditional.

Additionally, Alphabet has plenty of cash on its balance sheet and is generating significant losses in its “Other Bets” segment, increasing its P/E ratio relative to its core business and making it appear more expensive. And since it’s really unclear whether some of Alphabet’s ambitious plans will come to fruition, analysts likely aren’t expecting any contributions from these loss-making but forward-thinking companies, perhaps underestimating earnings growth prospects even further. of Alphabet.

And of course, in addition to a reasonable valuation, Meta’s new dividend is a good sign of the confidence that management places in the sustainability of its profits. So, both of these stocks may be worth looking at if you’re considering allocating to Magnificent Seven stock today.

A big surprise here is Nvidia, which actually emerges as the second cheapest title based on this metric. This is despite the highest price/earnings ratio of 73.5. This is of course because analysts are forecasting robust growth for Nvidia, based on its leadership in GPUs which currently dominate the artificial intelligence market. At first glance, it appears that analysts believe this advantage will endure and that the AI ​​revolution will generate high, sustainable growth for Nvidia in the immediate future.

Are the final four worth considering?

Tesla, Apple, Microsoft, and Amazon are all close to 2 or higher in terms of PEG ratios, making them generally unattractive on this metric.

However, this does not necessarily mean that these actions should be avoided. Remember that the PEG ratio is only a guideline, based on future earnings growth, which is somewhat unknowable.

Additionally, each of these companies has slightly different reasons for their high PEG ratios. Microsoft and Apple generally enjoy high valuations, not necessarily due to growth, but rather due to the stability of their businesses and confidence that profits will generally remain intact for a long period of time. Apple obviously has one of the best consumer franchises in the world with the iPhone, making it not just a technology title, but rather a core consumer product. And consumer staples stocks typically trade at higher valuations despite lower growth, due to their perceived “safety” in good or bad economic environments.

Microsoft is also considered a very safe bet, due to its dominance of not one but several high-profit companies, including the Windows operating system, the Office enterprise software suite and its cloud platform Azure computing. Add to that its exclusive deal with OpenAI, and it’s perhaps no surprise that Microsoft is receiving a lofty valuation that might be deserved.

On the other hand, Amazon and Tesla’s high PEGs are likely related to their high multiples today and considerable uncertainty about their future earnings.

Amazon has typically devoted all or most of its profits to future innovation, so its financial results are incredibly difficult to project, even though the company is generally doing well. It’s likely that Wall Street analysts aren’t forecasting a big swing in earnings, as is the case for Alphabet’s “other bets,” given that Amazon has never really reaped profits in a meaningful way .

At the same time, Tesla is a pioneer in the emerging electric vehicle market, which has high expectations for long-term growth. However, this market has slowed in recent months amid high interest rates, and Tesla’s profits are currently declining due to falling prices.

The combination of high long-term growth expectations and a likely drop in profits this year means Tesla is quite risky. In fact, I would personally own Amazon over Tesla, despite a slightly higher PEG, because I think Amazon is more likely to see earnings grow relative to current analyst expectations than Tesla.

Don’t just use PEG

The PEG ratio can be useful in providing a very quick snapshot of a company’s valuation relative to its growth. However, one factor that the PEG ratio doesn’t capture very well is how safe a company is relative to other stocks. P/E ratios reflect both growth expectations And risk, but risk is a very fragile concept and difficult to quantify.

Additionally, the biggest stock gains typically come from companies that far exceed expectations, so using a metric that simply reflects expectations is also a limiting factor. This is why the PEG ratio is best used for companies with stable earnings growth, not for results that may bounce back from year to year, like Amazon or Tesla.

Overall, the PEG ratio is just a shorthand for investors. But remember that the intrinsic value of a company is always the present value of future cash flows. If you come across a company that looks cheap based on a PEG ratio, see if you can dig deeper and determine what you think the cash flow can do over the next decade, as well as the likelihood that your projected scenario comes true.

While the PEG ratio is a useful shortcut, remember that it is more of a starting point than a destination.

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John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Randi Zuckerberg, former director of market development and spokesperson for Facebook and sister of Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Billy Duberstein holds positions at Alphabet, Amazon, Apple, Meta Platforms and Microsoft. Its clients may hold shares of the companies mentioned. The Motley Fool holds positions and recommends Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla. The Motley Fool recommends the following options: long January 2026 $395 calls on Microsoft and short January 2026 $405 calls on Microsoft. The Mad Motley has a disclosure policy.

This is the cheapest ‘Magnificent Seven’ stock, according to Peter Lynch’s preferred valuation metric was originally published by The Motley Fool