Are Wesfarmers Ltd shares overpriced?

In his seminal book One Up On Wall Street, fund manager Peter Lynch suggests using a chart plotting company earnings alongside the share price to quickly determine whether a company might be overvalued or not.

I’ve used his method on a popular Aussie company, Wesfarmers Ltd (ASX: WES), charting its underlying (excluding one-off items) earnings per share, share price, and Price to Earnings (P/E) multiple over the past 10 years:

source: Google Finance + company reports

source: Google Finance + company reports

What we’re looking at is the earnings per share (EPS; orange line) and share price (blue line) lines to see if they diverge widely. Gaps between them, such as in 2010, would suggest the company is moderately overvalued because the share price line rises substantially above the earnings line. Conversely, Wesfarmers might have been marginally undervalued in 2014 and 2015, although this could be due to nothing more than my using underlying earnings instead of statutory ones.

For the most part though, we can see that Wesfarmers is pretty fairly priced most of the time, no doubt due to its status as one of the most widely-held and followed companies on the ASX. Any opportunity is quickly identified and snapped up. The grey line on the chart is simply Wesfarmer’s Price to Earnings (P/E) ratio at each of those data points; it’s around 20 on average.

One key flaw

The trouble with this method is that it does not indicate whether a company is growing enough to deliver attractive returns. Buying Wesfarmers shares at $33 in 2010 still resulted in market-beating performance, despite it being ‘overpriced’ at this time. Shares have delivered price growth of approximately 5% per annum, plus another 4%-ish in dividends in the 6 years since then.

So this is not a method for picking great companies, it is simply a quick and dirty way of examining whether the companies you want to buy might be overpriced.

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Motley Fool contributor Sean O'Neill has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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