In his excellent book One Up on Wall Street, Peter Lynch, the best mutual fund manager ever, revealed a powerful charting tool that helped him to achieve a gain of 29.2% in his portfolios for 13 years. In this chart, Peter Lynch drew the stock price and the earnings per share together and aligned the value of $1 in earnings per share to $15 in stock price. He wrote in pages 164-165 of the book:
- Warren Buffett Recent Buys
- Warren Buffett's Current Portfolio
- This Powerful Chart Made Peter Lynch 29% A Year For 13 Years
"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 when the stock price fell well below the earnings line, and sold the m when the stock price rose dramatically above it, the chances are you'd do pretty well."
He also wrote what we now call "Peter Lynch Rule": "If the stock strays away from the earnings line, soon or later, it will come back to earnings." (One Up On Wall Street, page 163)
Peter Lynch Rule is clearly at work with Apple, the most valuable company on the earth. Below is the Peter Lynch chart of Apple (AAPL) from 1998 to 2000:
We can see that Apple stock prices have strong correlations with Apple's earnings. Just as Peter Lynch pointed out, the best times to buy Apple stocks were when the stock prices dipped below the earnings line, as in the beginning of 2009 and the middle of 2013.
In order to find the stocks that are traded below their earnings line, we have developed a Peter Lynch Below-Earnings-Line Screen. The screen filters for the stocks that had historically high correlations between the price lines and the earnings line, but currently traded at below the Earnings Line.
Median Sales Line
In addition to Earnings Line, this screen can also filters for the stocks that had historically high correlation between stock prices and sales, book value, EBITDA etc. For instance, Amazon (AMZN) have always been traded at around 2.1 times of sales over the past 10 years. Its stock prices are highly correlated with sales, as shown in the chart below:
Currently Amazon is traded below its historical Sales Line at 2.1 times of sales.
Median Book Value Line
T. Rowe Price (TROW) has been traded around 5 times of book value over the past two decades, as show in the chart below. The green price is the stock price and the blue line is the stock price at 5 times book value. If TROW were to trade at its historical median of 5 times book value, the stock price should be around $101 a share. Currently it is 23% lower.
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This article first appeared on GuruFocus.