This is the cheapest ‘Magnificent Seven’ stock, according to Peter Lynch’s favorite valuation metric

By | March 19, 2024

There’s been a lot of talk lately about the “Magnificent Seven” stocks. These large, competitively advantaged technology platforms have vastly outperformed the market over the past decade, and they also appear to be good opportunities to benefit from the artificial intelligence revolution.

But their strong recent run has led many to believe that these stocks are either overpriced or fairly priced compared to the rest of the market. On the other hand, many have been saying that for years, just to see these tech giants beat earnings expectations.

How can they balance their relatively high market valuations with their above-average growth prospects? One valuation metric touted by one of the most famous mutual fund managers of all time may hold the secret.

The PEG ratio

The PEG ratio, or price-earnings-growth measure, was first developed in 1969 by Mario Farina and later 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 price-to-earnings 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 obviously an imperfect measure, as some investors may use the price-to-earnings ratio while others use different time periods to calculate long-term earnings growth rates.

One standard type of PEG ratio is to look at the price-to-earnings ratio based on the current year’s expected earnings and the prospects for earnings growth over the next five years.

Great PEG ratios

Here’s how the PEG ratios of the Magnificent Seven stocks stack up.

Company

PEG ratio

Metaplatforms (NASDAQ: META)

1.10

Nvidia (NASDAQ: NVDA)

1.36

Alphabet (NASDAQ: GOOGL) (NASDAQ: GOOG)

1.49

Tesla (NASDAQ: TSLA)

1.93

Microsoft (NASDAQ: MSFT)

2.11

Apple (NASDAQ: AAPL)

2.12

Amazon (NASDAQ: AMZN)

2.36

Data source: Yahoo! Finances.

There are some expected results here, but also some surprises. First, it’s not surprising that both Meta and Alphabet are among the cheapest of these stocks. These two generally trade at discounts to other “disruptive” tech names, perhaps because they are already large, “mature” companies. In addition, many investors place less value on advertising revenues and profits because advertising revenues are believed to be economically sensitive and perhaps volatile.

Yet that has been the case for years, and both Alphabet and Meta have generally managed to defy the skeptics and continue their solid long-term growth as advertising dollars continue to flow from traditional advertising into digital advertising.

Furthermore, Alphabet has a lot of cash on its balance sheet and generates significant losses in the ‘Other Betting’ segment, increasing its price-to-earnings ratio relative to its core business and making it look more expensive. And since it’s very difficult to know whether some of Alphabet’s success projects will pay off, analysts are unlikely to predict any contribution from these loss-making but progressive companies, perhaps further underestimating Alphabet’s earnings growth prospects.

And in addition to a reasonable valuation, Meta’s new dividend is of course a good sign of management’s confidence in the sustainability of profits. So both stocks could be worth looking at if you’re considering investing in the Magnificent Seven shares today.

A big surprise here is Nvidia, which is actually the second cheapest stock based on this measure. This is despite the fact that it has the highest price-to-earnings ratio of 73.5. That’s of course because analysts are predicting robust growth for Nvidia based on its lead in GPUs that currently dominate the artificial intelligence market. From the looks of it, it appears that analysts believe the advantage will continue and that the AI ​​revolution will deliver sustainable high growth for Nvidia in the near term.

hand reaches for ascending graph. hand reaches for ascending graph.

Image source: Getty Images.

Are the bottom four worth considering?

Tesla, Apple, Microsoft, and Amazon all sit around 2 or higher in their PEG ratios, making them generally unattractive in this area.

However, that doesn’t necessarily mean you should avoid these stocks. Remember, the PEG ratio is just one indicator, based on future earnings growth that is somewhat unknowable.

Furthermore, each of these companies has slightly different reasons for their high PEG ratios. Both Microsoft and Apple generally receive high valuations, not necessarily because of growth, but rather because of the stability of their businesses and confidence that profits will generally remain intact for a long time. Apple clearly has one of the best consumer franchises in the world with the iPhone, making it not just a technology stock but more of a consumer product. And consumer staples stocks generally trade at higher valuations, despite lower growth, because of their perceived “safety” in both good and bad economic conditions.

Microsoft is also considered a very safe stock, due to its dominance of not one but several high-profit companies, including the Windows operating system, the Office enterprise software suite, and the Azure cloud computing platform. Add to that the exclusive agreement with OpenAI and it is perhaps no wonder that Microsoft receives a high rating that is perhaps well deserved.

On the other hand, the high PEGs for Amazon and Tesla likely have to do with their high multiples today and significant uncertainty about their future earnings.

Amazon has typically spent all or most of its profits on future innovation, so its outcome is incredibly difficult to predict even if the company is generally doing well. It’s likely that Wall Street analysts aren’t predicting much in the way of earnings, as is the case for Alphabet’s “other bets,” since Amazon has never really harvested profits in a significant way.

Meanwhile, Tesla is a pioneer in the emerging electric vehicle market, which has high long-term growth expectations. However, that market has slowed in recent months due to high interest rates, and Tesla’s revenues are actually falling as the company cuts prices.

The combination of high long-term growth expectations in the face of a likely earnings decline this year means Tesla is quite risky. In fact, I would personally own Amazon over Tesla, despite its slightly higher PEG, because I think Amazon is more likely to see earnings move higher compared to current analyst expectations than Tesla.

Do not use just the PEG

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

Furthermore, the biggest stock gains tend to come from companies that exceed expectations by a wide margin, so using a metric that merely reflects expectations is also a limiting factor. Therefore, the PEG ratio is best used for companies with stable earnings growth, and not for companies with operating income that can fluctuate from year to year, such as Amazon or Tesla.

Overall, the PEG ratio is just one shortcut for investors. But remember: 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 map out what you think its cash flow might do over the next ten years, as well as the likelihood that your forecast scenario will materialize. will unfold.

While the PEG ratio is a useful shortcut, keep in mind 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 spokeswoman for Facebook and sister of Mark Zuckerberg, CEO of Meta Platforms, is a member of The Motley Fool’s board of directors. Suzanne Frey, a director 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. His clients may own shares of the companies mentioned. The Motley Fool holds positions in and recommends Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla. The Motley Fool recommends the following options: long January 2026 $395 calls to Microsoft and short January 2026 $405 calls to Microsoft. The Motley Fool has a disclosure policy.

This Is the Cheapest ‘Magnificent Seven’ Stock, According to Peter Lynch’s Favorite Valuation Metric, originally published by The Motley Fool

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