Graham on Growth Stock Investing Part 1; Readings on Hyperinflation

Graham said that investors should stay away from growth stocks when their normalized P/Es go above 25. On the other hand, when the product of a stock’s normalized P/E and its price-to book ratio is less than 22.5—Normalized P/E x (price/book) is less than 22.5—it is at least a good value. So, if a normalized P/E is below 14 and the price/book is below1.5, the stock should be attractive.

One of the common criticisms made of Graham is that all the formulas in the 1972 edition of The Intelligent Investor are antiquated.  The best response is to say, ”Of course they are!” Graham constantly retested his assumption and tinkered with his formulas, so anyone who tries to follow them in any sort of slavish manner is not doing what Graham himself would do, if he were alive today.  —Martin Zweig

We continue our discussion from the last post:

Graham on Growth Stock Investing 

Graham displayed extraordinary skill in hypothesis testing. He observed the financial world through the eyes of a scientist and a classicist, someone who was trained in rhetoric and logic. Because of his training and intellect, Graham was profoundly skeptical of back-tested proofs. And methodologies that promote the belief that a certain investing approach is superior while another is inferior. His writing is full of warnings about time-period dependency….Graham argued for slicing data as many different ways as possible, across as many different periods as possible, to provide a picture that is likely to be more durable over time and out of sample.

Now we want to hear what Ben Graham has to say about valuing growth.  Graham later described his way of thinking as “searching, reflective, and critical.” He also had “a good instinct for what was important in a problem….the ability to avoid wasting time on inessentials….a drive towards the practical, towards getting things done, towards finding solutions, and especially towards devising new approaches and techniques.” (Source: The Memoirs of the Dean of Wall Street, 1996). His famous student, Warren Buffett, sums up Graham’s mind in two words: “terribly rational.”

Graham in the Preface to Security Analysis, 4th Edition

We believe that there are sound reasons for anticipating that the stock market will value corporate earnings and dividends more liberally in the future than it did before 1950. We also believe there are sound reasons for giving more weight than we have in the past to measuring current investment value in terms of the expectations of the future. But we recognize that both views lend themselves to dangerous abuses.  The latter has been a cause of excessively high stock prices in past bull market. However, the danger lies not so much in the emphasis on future earnings as on a lack of standards used in relating earnings growth to current values. Without standards no rational method of value measurement is possible.

Editor:  Note that when Graham wrote those words (1961/62) the bond yield/stock yield ratio was changing. In the early 1940s and 1950s for example, stock dividend yields were fully twice AAA bond yields, meaning that investors were only willing to pay half as much for one dollar of stock income as they were willing to pay for one dollar of bond income. In 1958, however, stock and bond yields were equal, meaning investors were at that time willing to pay just as much for a dollar of stock income as for a dollar of bond income.  And in recent years, investors have come to think so highly of equities, that they are now (March 1987) willing to pay three times as much for a dollar of stock income as they are for a dollar of bond income.   The main points you should extract from this and the following posts on Graham’s discussion of growth stock investing is his thinking process.  Graham was adaptable. Ironically, Graham was known for his net/net investing but he made most of his money owning GEICO.

Newer Methods for Valuing Growth Stocks (Chapter 39 of Security Analysis, 4th Ed.)

PART 1 of 4 (entire article to be posted as a pdf next week)

Historical Introduction

We have previously defined a growth stock as one which has increased its per-share for some time in the past at faster than the average rate and is expected to maintain this advantage for some time in the  future. (For our own convenience we have defined a true growth stock as one which is expected to grow at the annual rate of at least 7.2%–which would double earnings in ten years, if maintained—but others may set the minimum rate lower.) A good past record and an unusually promising future have, of course, always been a major attraction to investors as well as speculators.  In the stock markets prior to the 1920s, expected growth was subordinated in importance, as an investment factor, to financial strength and stability of dividends. In the late 1920s, growth possibilities became the leading consideration for common stock investors and speculators alike. These expectations were though to justify the extremely high multipliers reached for the most favored issues. However, no serious efforts were then made by financial analysts to work out mathematical valuations for growth stocks.

The first detailed basis for such calculations appeared in 1931—after the crash—in S.E. Guild’s book, Stock Growth and Discount Tables. This approach was developed into a full-blown theory and technique in J.B. William’s work, The Theory of Investment Value, published in 1938. The book presented in detail the basic thesis that a common stock is worth the sum of all its future dividends, each discounted to its present value. Estimates of the rates for future growth must be used to develop the schedule of future dividends, and from them to calculate total recent value.

In 1938 National Investor’s Corporation was the first mutual fund to dedicate itself formally to the policy of buying growth stocks, identifying them as those which had increased their earnings from the top of one business cycle to the next and which could be expected to continue to do so. During the next 15 years companies with good growth records won increasing popularity, but little effort at precise valuations of growth stocks was made.

At the end of 1954 the present approach to growth valuation was initiated in an article by Clendenin and Van Cleave, entitled “Growth and Common Stock Values.”[1] This supplied basic tables for finding the present value of future dividends, on varying assumptions as to rate and duration of growth, and also as to the discount factor. Since 1954 there has been a great outpouring of articles in the financial press—chiefly in the Financial Analysts Journal—on the subject of the mathematical valuation of growth stocks. The articles cover technical methods and formulas, applications to the Dow-Jones Industrial Average and to numerous individual issues, and also some critical appraisals of growth-stock theory and of market performance of growth stocks.

In this chapter we propose: (1) to discuss in as elementary form as possible the mathematical theory of growth-stock valuation as now practiced; (2) to present a few illustrations of the application of this theory, selected from the copious literature on the subject; (3) to state our views on the dependability of this approach, and even to offer a very simple substitute for its usually complicated mathematics.

The “Permanent – growth-rate” Method

An elementary-arithmetic formula for valuing future growth can easily be found if we assume that growth at a fixed rate will continue in the indefinite future. We need only subtract this fixed rate of growth from the investor’s required annual return; the remainder will give us the capitalization rate for the current dividend.

This method can be illustrated by a valuation of DJIA made in a fairly early article on the subject by a leading theoretician in the field.[2]  This study assumed a permanent growth rate of 4 percent for the DJIA and an over-all investor’s return (or discount rate”) of 7 percent. On this basis the investor would require a current dividend yield of 3 percent, and this figure would determine the value of the DJIA. For assume that the dividend will increase each year by 4 percent, and hence that the market price will increase also by 4 percent. Then in any year the investor will have a 3 percent dividend return and a 4 percent market appreciation—both below the starting value—or a total of 7 percent compounded annually. The required dividend return can be converted into an equivalent multiplier of earning by assuming a standard payout rate. In this article the payout was taken at about two-thirds; hence the multiplier of earnings becomes 2/3 of 33 or 22.[3]

It is important for the student to understand why this pleasingly simple method of valuing a common stock of group of stocks had to be replaced by more complicated methods, especially in the growth stock field. It would work fairly plausibly for assumed growth rates up to say, 5 percent. The latter figure produces a required dividend return of only 2 percent, or a multiplier of 33 for current earnings, if payout is two-thirds. But when the expected growth rate is set progressively higher, the resultant valuation of dividends or earnings increases very rapidly. A 6.5% growth rate produces a multiplier of 200 for the dividend, and a growth rate of 7 percent or more makes the issue worth infinity if it pays any dividend. In other words, on the basis of this theory and method, no price would be too much to pay for such common stock.[4]

A Different Method Needed.

Since an expected growth rate of 7 percent is almost the minimum required to qualify an issue as a true “growth stock” in the estimation of many security analysts, it should be obvious that the above simplified method of valuation cannot be used in that area. If it were, every such growth stock would have infinite value. Both mathematics and prudence require that the period of high growth rate be limited to a finite—actually a fairly short—period of time. After that, the growth must be assumed either to stop entirely or to proceed at so modest a rate as to permit a fairly low multiplier of the later earnings.

The standard method now employed for the valuation of growth stocks follows this prescription. Typically it assumes growth at a relatively high rate—varying greatly between companies –for a period of ten years, more or less. The growth rate thereafter is taken so low that the earnings in the tenth of other “target” year may be valued by the simple method previously described. The target-year valuation is then discounted to present worth, as are the dividends to be received during the earlier period. The two components are then added to give the desired value.

Application of this method may be illustrated in making the following rather representative assumptions: (1) a discount rate, or required annual return of 7.5%;[5] (2) an annual growth rate of about 7.2% for a ten-year period—i.e., a doubling of earnings and dividends in the decade; (3) a multiplier of 13.5% for the tenth year’s earnings. (This multiplier corresponds to an expected growth rate after the tenth year of 2.5%, requiring a dividend return of 5 percent. It is adopted by Molodovsky as a “level of ignorance” with respect to later growth. We should prefer to call it a “level of conservatism.” Our last assumption would be (4) an average payout of 60 percent. (This may well be high for a company with good growth.)

The valuation per dollar of present earnings, based on such assumptions, works out as follows:

  1. Present value of tenth year’s market price: The tenth year’s earnings will be $2, their market price 27, and its present value 48 percent of 27, or about $13.
  2. Present value of next ten years’ dividends: These will begin at 60 cents, increase to $1.20, average about 90 cents, aggregate about $9, and be subject to a present-worth factor of some 70 percent –for an average waiting period of five years. The dividend component is thus worth presently about $6.30.
  3. Total present value and multiplier: Components A and B add up to about $19.30, or a multiplier of 19.3 for the current earnings.

[1] Journal of Finance, December 1954

[2] See N. Molodovskiy, “An appraisal of the DJIA.” Commercial and Financial Chronical, Oct. 30, 1958

[3] Molodovsky here assume a “long-term earning level” of only $25 for the unit in 1959, against the actual figure of $34. His multiplier of 22 produced a valuation of 550. Later he was to change his method in significant ways, which we discuss below.

[4] David Durand has commented on the parallel between this aspect of growth stock valuation and the famous mathematical anomaly known as the “Petersburg Paradox.”

[5] Molodovsky’s later adopted this rate in place of his earlier 7 percent, having found that 7.5% per year was the average over-all realization by common-stock owners between 1871 and 1959. It was made up of a 5 percent average dividend return and a compounded annual growth rate of about 2.5% percent in earnings, dividends, and market price.

Part 2: Valuation of DJIA in 1961 by This Method…….stay tuned.



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