Using GuruFocus’s Peter Lynch charts can provide a quick, yet powerful snapshot of an equity’s valuation with respect to the earnings multiple. But a simple view that price should continuously mimic a static earnings line can lead to improper valuations. Peter Lynch stresses to categorize companies into, "slow growers, medium growers, fast growers, cyclicals, asset plays, and turnarounds," in his bestseller, One Up On Wall Street. One must also view the current situation in combination of these charts to get the correct valuation range. Setting a simple earnings multiple of 15 may lead one to observe an undervaluation when the stock is properly valued. Using Westlake Chemical (WLK, Financial) as an example explains this issue. If one were to view the years 2004-07, he or she would see a severe underperformance of the price with the earnings line set at P/E=15.
Analyzing the earnings performance from 2004-07 shows quality revenue growth with a stronger growth in gross costs. Thus, actual earning power was deteriorating each year. Peter Lynch would categorized Westlake as a slow grower, thus undeserving of a P/E ratio of 15. If we were to use the actual average earnings multiple line over this period (P/E=10), we would conclude Westlake was properly valued from an earnings multiple standpoint.
But as time changes, so does the equity’s valuation and appropriate multiple. Viewing the periods from 2010-14 explains the changes. Income statement analysis shows ample revenue growth as well as margin percentage growth. Though the 2004-07 period had a more impressive revenue growth, cost cutting in the latter period provided a boost to earnings growth. Peter Lynch might categorize Westlake as a medium grower during 2010-14, justifying a multiple similar to the market. Using Westlake's average earnings multiple of about 14 during the 2010-14 period follows the price action harmoniously. Viewing the chart with the default P/E of 15 shows little difference.
Though analyzing the earnings multiple for a correct valuation just scratches the surface in a company analysis, properly using the Peter Lynch charts creates the value in this effective tool.
