In his excellent book, "One Up on Wall Street," Peter Lynch used many charts that look like the one below to illustrate the valuation of stocks.
Regarding the chart, he wrote in pages 164 to 165 of the book: “A quick way to tell if a stock is overpriced is to compare the price line to the earnings line. If you bought familiar growth companies – such as Shoney’s, The Limited, or Marriott – when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you’d do pretty well.”
In this chart, Peter Lynch drew the stock prices on the right axis and the earnings on the left axis. The charts are in logarithmic scale. He aligned the value of $1 in earnings per share to $15 in stock prices. Therefore, if we draw in stock prices, the “earnings line” he mentioned above is equal to the stock prices at a P/E ratio of 15.
1. Fill in "15" in Price at "P/E = 15" and check the checkbox.
2. Click on "Logarithmic" in the top right corner.
That’s it. You get charts like this:
According to Peter Lynch, the best buying time will be when the green line (price) is lower than the blue line (earnings line). In this case, it would be around the middle of 2011. Indeed, if you bought Wal-Mart in June 2011 around $54, you have gained more than 40% in about two years. Not bad from a large company like Wal-Mart.
Is Wal-Mart a good buy right now? Probably not, as the price line and the earnings line are almost overlapped. This suggests that the stock is now fully valued.
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Update: We have added Pre-defined chart settings in our Interactive Charts. You can select "Peter Lynch Charts" there and it will be displayed immediately.