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Chapter 39: Price-Earnings Ratios for Common Stocks. Adjustments for Changes in Capitalization

Aspect of Investment Finance: Valuation – Determining a Price Earnings Multiple

·         A given common stock is generally considered to be worth a certain number of times its current earnings by Wall Street. This multiplier, depends partly on the prevailing psychology and partly on the nature and record of the enterprise. Prior to 1927-29 bull market 10 times earnings was the accepted standard of measurement – it is the common point of departure for valuing common stocks, so that an issue would have to be considered exceptionally desirable to justify a higher ratio, and conversely.

·         Exact appraisal impossible: Security analysis cannot presume to lay down general rules as to the proper value of any given common stock. Practically speaking, there is no such thing. The bases of value are too shifting to admit of any formulation that could claim to be even reasonably accurate.

·         Limited functions of the analyst in field of appraisal of stock prices: Confronted by a mixture of changing facts and fluctuating human fancies, the securities analyst is clearly incapable of passing judgment on common-stock prices generally. There are, however, some concrete, if limited, functions that he may carry on in this field, of which the following are representative

§  He may set up a basis for conservative or investment valuation of common stocks, as distinguished from speculative valuations.

§  He may point out the significance of the capitalization structure and source of income as bearing upon the valuation of a given stock issue

§  He may find unusual elements in the balance sheet which affect the implications of the earnings picture.

·         A suggested basis of maximum appraisal for investment: The investor in common stocks, equally with the speculator, is dependent on future rather than past earnings. His fundamental basis of appraisal must be an intelligent and conservative estimate of the future earning power. But his measure of future earnings can be conservative only if it limited by actual performance over a period of time.

§  The profits of the most recent year, taken singly, might be accepted as the gage of future earnings, if (1) general business conditions in that year were not exceptionally good, (2) the company has shown an upward trend of earnings for some years past and (3) the investor’s study of the industry gives him confidence in its continued growth.

§  Only in a very exceptional case, the investor may be justified in counting on higher earnings in the future than at any time in the past. This might follow from developments involving a patent or the discovery of new ore or some similar specific and significant occurrence.

§  In most instances the investor should derive the investment value of common stock from the average earnings of a period between five and ten years. This does not mean that all common stocks with the same average earnings should have the same value. The common stock investor will properly accord a more liberal valuation to those issues which have current earnings above the average or which may reasonably considered to posses better than average prospects or an inherently stable earning power.

§  The essence of Graham’s view is that some moderate upper limit must in every case be placed on the multiplier in order to stay within the bounds of conservative valuation. He suggests that about 20 times average earnings is as high a price as can be paid in an investment purchase of a common stock.

s  Investment presupposes demonstratable value and the typical common stock’s value can be demonstrated only by means of an established i.e. earnings power. But it is difficult to see how average earnings of less than 5% upon the market price could every be considered as vindicating that price. Clearly such a PE ratio could not provide that margin of safety which we have associated with the investor’s position.

s  It might be accepted by a purchaser in the expectation that future earnings will be larger than in the past. But in the original and most useful sense of the term such a basis of valuation is speculative. It falls outside the purview of common stock investment.

§  Higher prices may prevail for speculative commitments. Graham asks us to note this distinction. It is not a mistake to pay more than 20 times average earnings for any common stock. He suggests that such a price would be speculative. The purchase may turn out to be highly profitable, but in that case it will have proved a wise or fortunate speculation – and very few people are consistently wise or fortunate in their speculative operations. As a corollary, he suggests, that people who habitually purchase common stocks at more than 20 times their average earnings are likely to lose considerable sums of money in the long run. This is more probable because, in the absence of such a mechanical check, they are prone to succumb recurrently to the lure of bull markets, which always find some specious argument to justify paying extravagant prices for common stocks.

§  Other requisites for common stocks of investment grade. If 20 times average earnings is the upper limit of price for investment purchase, then ordinarily the price paid should be substantially less than this maximum. This suggests that about 12 or 12.5 times average earnings may be suitable for the typical case of a company with neutral prospects. A reasonable ratio of market price to average earnings is not the only requisite for a common stock investment. This is a necessary but not a sufficient condition. The company must be satisfactory also in its financial setup and management, and not unsatisfactory in its prospects.

s  An important corollary of this: An attractive common-stock investment is an attractive speculation. This is true because, if a common stock can meet the demand of a conservative investor that he get full value for this money plus not unsatisfactory future prospects, then such an issue must also have a fair chance of appreciation in market value.

·         Examples of speculative and Investment common stocks: Common stock investment operations, as Graham defines them, occupy a middle ground in the market, lying between low price issues that are speculative because of doubtful quality and well entrenched issues that are speculative, none the less, because of their high price. Graham presents three categories of companies to illustrate the differences between investment and speculative stocks.

§  Group A: Blue chip or first grade stocks which are characterized by strong financial position, presumably excellent prospects and in most cases by relatively stable or growing earnings in the past. They sell at high prices relative to earnings and at enormous premiums above the actual capital invested. The high prices paid for the best common stocks make these purchases essentially speculative, because they require future growth to justify them.

§  Group B: Speculative because of great instability of their earnings records. They have varying relationships of market price to average earnings, maximum earnings and asset values.

§  Group C: Those that meet specific and quantitative tests of investment quality including – earnings are reasonably stable, average earnings bear satisfactory ratio to market price and financial setup is sufficiently conservative and working capital position is strong. Another characteristic (though not required) is that they will not sell for a huge premium above the companies actual resources.

Common stock investment will confine itself to issues similar to Group C. But the actual purchase of any such issues must require also that the purchaser be satisfied in his own mind that the prospects of the enterprise are at least reasonable favorable.

·         Allowances for changes in capitalization: When the change in capitalization has been due to the sale of additional stock at a comparatively low price, the earnings available for common during the earlier period must be increased by whatever gain would have followed from the issuance of the additional shares.

§  When bonds or preferred shares have been converted into common, the charges formerly paid are to be added back to the earnings and the new figure then applied to the larger number of shares.

§  A corresponding adjustment of per share earnings must be made at times to reflect the possible future increase in the number of shares outstanding as a result of conversions or exercise of stock options.

§  Whenever a stock is subject to dilution by stock options or through participating privileges enjoyed by other securities holders, the analyst must assume that the exercise or conversion takes place in full and adjust the earnings accordingly.

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