Peter Lynch used many charts in his book “One Up on Wall Street” to do stock valuation. He believed a quick way to tell if a stock is overpriced is to compare the price line to the earnings line. He wrote: “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 his charts, Peter Lynch used a P/E ratio of 15 to drew the so called “earnings line,” which is to use companies’ trailing-twelve-month earnings multiplied by 15 to predict the future prices of the stock. The charts are in logarithmic scale. According to Peter Lynch, the best buying time will be when the price line is lower than the earnings line. Using GuruFocus Financial Charts tools, you can easily access Peter Lynch Charts of more than 50,000 stocks worldwide. For instance, you can get Wal-Mart Stores Inc. (WMT)'s Peter Lynch chart by clicking Interactive Chart, choosing “Peter Lynch Chart” under “User Defined Chart” on the left corner above the chart.
In my last research Earnings, Free Cash Flow, Book Value? Which Parameters Are Stock Prices Most Correlated To?, we find out that stock price performances are more correlated to book value per share, EBITDA per share and operating income per share over long term. After doing that, it makes me think which stocks' prices are most correlated to book value per share, earnings per share, sales per share, EBITDA per share and operating income per share. If, for instance, one stock’s price is highly correlated to book value, then similar to what did Peter Lynch did, we can generate a new chart which may serve better than the Peter Lynch chart to value this stock.
Furthermore, if the price of a stock is closely correlated to its earnings, book value or sales, the chances are it will continue to be closely correlated in the future. In this way, we can screen for the stocks that have historically had close correlations with earnings, book value or sales, and they are now traded at below their Earnings Line, Book Value Line, or Sales Lines. In the case of Earnings Line, we can screen for the stocks that Peter Lynch referred to as “the stock price fell well below the earnings line,” and we will probably “do pretty well.”
In statistics, the coefficient of determination, denoted R squared, indicates how well data points fit a line or curve. In our case, we use the linear regression. I use quarterly data (some companies reported semiannually which we use semiannual data) to do regression of stock price and business performance parameters for the recent 10 years and then find which parameters are most correlated to stock price. These parameters include book value per share, earnings per share, revenue per share, EBITDA per share and operating income per share. Using programming, I ran the R squared for all the stocks which have at least 10-year history with complete data. The higher the R squared, the better the stock price is correlated to those business performance parameters. During the research, I use median P/B, P/E, P/S, P/EBITDA and P/Operating Income to project the stock prices. In this way, when the stock price line is lower than the projected price line, or I should call them book value line and so forth, the stock is considered undervalued.
Using programming, I get five lists of stocks which are highly correlated to each of those business performance parameters among the more than 60,000 stocks that we cover with GuruFocus Global Membership.
Book Value Per Share
|Table 1: Book Value Per Share|
2. Aberdeen New Dawn Investment Trust PLC (LSE:ABD) (R Squared = 0.9822)
3. MBIA Inc. (NYSE:MBI) (R Squared = 0.9621)
From above three charts, we can observe that the projected prices using median P/B ratio time book value each quarter are highly correlated with the real quarterly ending stock prices. Now the stock price line is lower than the so-called book value line which means these stocks might be undervalued.
Earnings Per Share
|Table 2: Earnings Per Share|
2. Mulberry Group PLC (LSE:MUL) (R Squared = 0.9366)
3. Mermaid Marine Australia Limited (ASX:MRM) (R Squared = 0.9347)
The above three stocks are highly correlated with the earnings line (median P/E ratio times annually earnings) and the price line is lower than the earnings line now.
Sales Per Share
|Table 3: Sales Per Share|
2. Directv (NAS:DTV) (R Squared = 0.9397)
3. Deutsche Bank AG (XTER:DBK) (R Squared = 0.9152)
The above three stocks’ quarterly ending prices are highly correlated with the sales line (median P/S ratio times annually sales) and the price line is lower than the sales line.
EBITDA Per Share & Operating Income Per Share
|Table 4: EBITDA Per Share||Table 5: Operating Income Per Share|
|Ticker||Exchange||R Squared||Ticker||Exchange||R Squared|
The above two tables are the list of top 20 companies whose projected quarterly prices are highly correlated with the quarterly ending trading prices.
For the companies that have enough history, around 5% of them have R squared bigger than 80%, another 5% have R squared ranged from 70% to 80%, and 10% of them have R squared from 60% to 70%. From above research, we can see different stocks might be highly correlated with different business performance parameters. For those highly correlated stocks with one of the business performance parameters, we can draw their performance parameter line using the stocks’ interactive chart, just like what did Peter Lynch did, to value the stocks.
For the next step, we will create a screener for the stocks whose prices have the highest correlation with the earnings, book value or sales, and their current prices are “well below” the Earnings Line, Book Value Line or Sales Line. Combined with requirement on the companies’ financial strength and growth, this can serve as the Peter Lynch Screener. Stay tuned.
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