In previous chapters various references have been made to Wall Street’s ideas on the relation of earnings to values. A given common stock is generally considered to be worth a certain number of times its current earnings. This number of times, or multiplier, depends partly on the prevailing psychology and partly on the nature and record of the enterprise. Prior to the 1927—1929 bull market ten times earnings was the accepted standard of measurement. More accurately speaking, it was the common point of departure for valuing common stocks, so that an issue would have to be considered exceptionally desirable to justify a higher ration, and conversely.
Beginning about 1927 the ten-times-earnings standard was superseded by a rather confusing set of new yardsticks. On the one hand, there was a tendency to value common stocks in general more liberally than before. This was summarized in a famous dictum of a financial leader implying that good stocks were worth fifteen times their earnings. There was also the tendency to make more sweeping distinctions in the valuations of different kinds of common stocks. Companies in especially favored grounps, e.g., public utilities and chain stores, in 1928—1929, sold at a very high multiple of current earnings, say, twenty-five to forty times. this was true also of the “blue chip” issues, which comprised leading units in miscellaneous fields. As pointed out before, these generous valuations were based upon the assumed continuance of the upward trend shown over a longer or shorter period in the past. Subsequent to 1932 there developed a tendency for prices to rule higher in relation to earnings because of the sharp drop in long-term interest rates.
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. The whole idea of basing the value upon current earnings seems inherently absurd, since we know that the current earnings are constantly changing. And whether the multiplier should be ten or fifteen or thirty would seem at bottom a matter of purely arbitrary choice.
But the stock market itself has no time for such scientific scruples. It must make its values first and find its reasons afterwards. Its position is much like that of a jury in a breach-of-promise suit; there is no sound way of measuring the values involved, and yet they must be measured somehow and a verdict rendered. Hence the prices of common stocks are not carefully thought out computations but the resultants of a welter of human reactions. The stock market is a voting machine rather than a weighing machine. It responds to factual data not directly but only as they affect the decisions of buyers and sellers.
Limited Functions of the Analyist in Field of Appraisal of Stock Prices. Confronted by this mixture of changing facts and fluctuating human fancies, the securities analyst is clearly incapable of passing judgement 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: (a) the capitalization structure; and (b) the 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 is limited by actual performance over a period of time. We have suggested, however, that 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 investors’s study of the industry gives him confidence in its continued growth. 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 in a mine or some similar specific and significant occurrence. But in most instances he will derive the investment value of a 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 (*i.e., *the conservative buyer) will properly accord a more liberal valuation to those issues which have current earnings above the average or which may reasonably be considered to possess better than average prospects or an inherently stable earning power. But it is the essence of our viewpoint that some moderate upper limit must in every case be placed on the multiplier in order to stay within the bounds of conservative valuation. We would suggest that about 20 times average earnings is as high a price as can be paid in an investment purchase of a common stock.
Although this rule is of necessity arbitrary in its nature, it is not entirely so. Investment presupposes demonstrable value, and the typical common stock’s value can be demonstrated only by means of an established, i.e., an average, earning power. But it is difficult to see how average earnings of less than 5% upon the market price could ever be considered as vindicating that price. Clearly such a price-earnings ratio could not provide that margin of safety which we have associated with the investor’s position. 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. The intent of this distinction must be clearly understood. We do not imply that it is a mistake to pay more than 20 times average earnings for any common stock. We do suggest that such a price would be speculative. The purchase may easily turn out to be highly profitable, but in that case it will have proved a wise or fortunate speculation. It is proper to remark, moreover, that very few people are consistenly wise or fortunate in their speculative operations. Hence we may submit, as a corollary of no small practical importance, that people who habitually purchase common stocks at more than about 20 times their average earnings are likely to lose considerable money in the long run. This is the 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 and a Corollary Therefrom. It should be pointed out that if 20 times average earnings is taken as the upper limit of price for an investment purchase, then ordinarily the price paid should be substantially less than this maximum. This suggests that about 12 or 12½ times average earnings may be suitable for the typical case of a company with neutral prospects. We must emphasize also that a reasonable ratio of market price to average earnings is not the only requisite for a common-stock investment. It is a necessary but not a sufficient condition. The company must be satisfactory also in its financial set-up and management, and not unsatisfactory in its prospects.
From this principle there follows another important corollary, viz.: 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 his money plus not unsatisfactory future prospect, then such an issue must also have a fair chance of appreciating in market value.
Examples of Speculative and Investment Common Stocks. Our definition of an investment basis for common-stock purchases is at variance with the Wall Street practice in respect to common stocks of high rating. For such issues a price of considerably more than 20 times average earnings is held to be warranted, and furthermore these stocks are designated as “investment issues” regardless of the price at which they sell. According to our view, the high prices paid for “the best common stocks” make these purchases essentially speculative, because they require future growth to justify them. Hence common-stock investment operations, as we define them, will 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.
Group A: Common stocks speculative in December 1938 because of their high price (figures adjusted to reflect changes in capitalization)
| Item | General Electric | Coca Cola | Johns-Manville |
|---|---|---|---|
| Amount Earned per Share of Common: | |||
| 1938 | $0.96 | $5.95 | $1.09 |
| 1937 | 2.20 | 5.73 | 5.80 |
| 1936 | 1.52 | 4.66 | 5.13 |
| 1935 | 0.97 | 3.48 | 2.17 |
| 1934 | 0.59 | 3.12 | 0.22 |
| 1933 | 0.38 | 2.20 | 0.64(d) |
| 1932 | 0.41 | 2.17 | 4.47(d) |
| 1931 | 1.33 | 2.96 | 0.45 |
| 1930 | 1.90 | 2.79 | 3.66 |
| 1929 | 2.24 | 2.56 | 8.90 |
| 10-yr. average | $1.25 | $3.56 | $$2.15 |
| 5-yr. average (1934—1938) | $1.25 | $4.59 | $2.88 |
| Bonds | None | None | None |
| Pfd. Stock | None | 600,000 sh. @60, $36,000,000 | 75,000 sh. @130, $9,750,000 |
| Common Stock | 28,784,000 sh. @43½, $1,250,000,000 | 3,992,000 sh. @132¼, $529,000,000 | 850,000 sh. @ 105, $89,300,000 |
| Total capitalization | $1,250,000,000 | $565,500,000 | $99,050,000 |
| Net tangible assets, 12/31/38 | $335,182,000 | $43,486,000 | $48,001,000 |
| Net current assets, 12/31/38 | $155,023,000 | $25,094,000 | $$17,418,000 |
| Average earnings on common-stock price, 1929—1938 | 2.9% | 2.7% | 2.0% |
| Maximum earnings on common-stock price, 1929—1938 | 5.1% | 4.5% | 7.7% |
| Minimum earnings on common-stock price, 1929—1938 | 0.9% | 1.6% | (d) |
| Average earnings on common-stock price, 1934—1938 | 2.9% | 3.5% | 2.7% |
These distinctions are illustrated by the acompanying nine examples, taken as of December 31, 1938.
Comments on the Various Groups. The companies listed in Group A are representative of the so-called “first-grade” or “blue chip” industrials, which
| Item | Goodyear Tire and Rubber | Simmons | Youngstown Sheet and Tube |
|---|---|---|---|
| Amount earned per share of common: | |||
| 1938 | $1.34 | $1.42 | $0.89(d) |
| 1937 | 1.95 | 2.88 | 6.79 |
| 1936 | 3.90 | 3.53 | 7.03 |
| 1935 | 0.12 | 1.14 | 0.64 |
| 1934 | 0.66(d) | 0.84(d) | 2.95(d) |
| 1933 | 0.79(d) | 0.04 | 7.76(d) |
| 1932 | 4.24(d) | 2.57(d) | 11.75(d) |
| 1931 | 0.04 | 0.79(d) | 6.55(d) |
| 1930 | 0.37(d) | 1.05(d) | 5.17 |
| 1929 | 10.23 | 4.15 | 17.28 |
| 10-yr. average | $1.15 | $0.79 | $0.70 |
| 5-yr. average(1934—1938) | $1.35 | $1.63 | $2.12 |
| Bonds | $50,235,000 | $10,000,000 | $87,000,000 |
| Pfd. stock | 650,000 sh. @ 108, 70,250,000 | None | 150,000 sh. @ 81, 12,165,000 |
| Common stock | 2,059,000 sh. @ 37 5/8, $77,500,000 | 1,158,000 sh. @ 32, $37,070,000 | 1,675,000 sh. @ 54¼, $90,900,000 |
| Total capitalization | $197,985,000 | $47,050,000 | $190,065,000 |
| Net tangible assets, 12/31/38 | $170,322,000 | $28,446,000 | $224,678,000 |
| Net current assets, 12/31/38 | $96,979,000 | $14,788,000 | $83,375,000 |
| Average earnings on common-stock price, 1929—1938 | 3.1% | 2.5% | 1.3% |
| Maximum earnings on common-stock price, 1929—1938 | 27.2% | 13.0% | 31.8% |
| Minimum earnings on common-stock price, 1929—1938 | (d) | (d) | (d) |
| Average earnings on common-stock price, 1934—1938 | 3.6% | 5.1% | 3.9% |
were particularly favored in the great speculation of 1928—1929 and in the markets of ensuing years. They are characterized by a strong financial position, by presumably excellent prospects and in most cases by relatively stable or growing earnings in the past. The market price of the shares, however, was higher than would be justified by their average earnings. In fact the profits of the best year in the 1929—1938 decade were less than 8% of the
| Item | Adams-Mills | American Safety Razor | J.J. Newberry |
|---|---|---|---|
| Amount earned per share of common: | |||
| 1938 | $3.21 | $1.48 | $4.05 |
| 1937 | 2.77 | 2.47 | 5.27 |
| 1936 | 2.55 | 2.70 | 6.03 |
| 1935 | 2.93 | 2.42 | 4.94 |
| 1934 | 3.41 | 2.03 | 5.38 |
| 1933 | 2.63 | 1.40 | 3.06 |
| 1932 | 1.03 | 1.14 | 1.07 |
| 1931 | 4.72 | 1.58 | 1.73 |
| 1930 | 4.83 | 2.50 | 2.27 |
| 1929 | 4.83 | 2.57 | 3.15 |
| 10-yr. average | $3.29 | $2.03 | $3.70 |
| 5-yr. average (1934–1938) | $2.97 | $2.22 | $5.13 |
| Bonds | None | None | $5,587,000 |
| Pdf. stock | None | None | 51,000 sh. @ 106, $5,405,000 |
| Common stock | 156,000 sh. @ 21, $3,280,000 | 524,000 sh. @ 14 7/8, $7,800,000 | $13,110,000 |
| Total capitalization | $3,280,000 | $7,800,000 | $13,110,000 |
| Net tangible assets, 12/31/1938 | $3,320,000 | $6,484,000 | $25,551,000 |
| Net current assets, 12/31/38 | $926,000 | $3,649,000 | $8,745,000 |
| Average earnings on common-stock price, 1929—1938 | 15.7% | 13.7% | 10.7% |
| Maximum earnings on common-stock price, 1929—1938 | 23.0% | 18.2% | 17.5% |
| Minimum earnings on common-stock price, 1929—1938 | 4.9% | 7.7% | 3.1% |
| Average earnings on common-stock price, 1934—1938 | 14.1% | 14.9% | 14.9% |
December 1938 market price. It is also characteristic of such issues that they sell for enormous premiums above the actual capital invested.
The companies analyzed in Group B are obviously speculative, because of the great instability of their earnings records. They show varying relationships of market price to average earnings, maximum earnings, and asset values.
The common stocks shown in Group C are examples of those which meet specific and quantitative tests of investment quality. These tests include the following:
- The earnings have been reasonably stable, allowing for the tremendous fluctuations in business conditions during the ten-year period.
- The average earnings bear a satisfactory ratio to market price.
- The financial set-up is sufficiently conservative, and the working-capital position is strong.
Although we do not suggest that a common stock bought for investment be required to show asset values equal to the price paid, it is non the less characteristic of issues in Group C that, as whole, they will not sell for a huge premium above the companies’ actual resources.
Common-stock investment, as we envisage it, will confine itself to issues making exhibits of the kind illustrated by 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 reasonably favorable.
In dealing with the past record of earnings, when given on a per-share basis, it is elementary that the figures must be adjusted to reflect any important changes in the capitalization which have taken place during the period. In the simplest case these will involve a change only in the number of shares of common stock due to stock dividends, split-ups, etc. All that is necessary then is to restate the capitalization throughout the period on the basis of the current number of shares. (Such recalculations are made by some of the statistical services but not by others.)
When the change in capitalization has been due to the sale of additional stock at a comparatively low price (usually through the exercise of subscription rights or warrants) or to the conversion of senior securities, the adjustement is more difficult. In such cases the earnings available for the 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 stocks have been converted into common, the charges formerly paid theron are to be added back to the earnings and the new figure then applied to the larger number of shares. If stock has been sold at a relatively low price, a proper adjustment would allow earnings of, say, 5 to 8% on the proceeds of the sale. (Such recalculations need not be made unless the changes indicated thereby are substantial.)
A corresponding adjustment of the 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 option warrnts. When other security holders have a choice of any kind, sound analysis must allow for the possible adverse effect upon the per-share earnings of the common stock that would follow from the exercise of the option.
Examples: This type of adjustment must be made in analyzing the reported earnings of American Airlines, Inc., for the 12 months ended September 30, 1939.
| Earnings as reported | $1,128,000 |
| Per share on about 300,000 shares outstanding | $3.76 (Price December 1939 about 37) |
But there were outstading $2,600,000 of 4½% debentures, convertible into common stock at $12.50 per share. The analyst must assume conversion of the bonds, giving the following adjusted result:
| Earnings, adding back $117,000 interest | $1,245,000 |
| Per share on 508,000 shares | $2.45 |
More than one-third of the reported earnings per share are lost when the necessary adjustment is made.
American Water Works and Electric Company can be used to illustrate both types of adjustment.
Adjustment A reflects the payment of stock dividends in 1928, 1929 and 1930.
Adjustment B assumes conversion of the $15,000,000 of convertible 5s, issued in 1934, thus increasing the earings by the amount of the interest charges but also increasing the common-stock issue by 750,000 shares. (The foregoing adjustements are independent of any possible modifications in the reported earnings arising from the questioning of the depreciation charges, etc., as previously discussed.)
| Year | Amount of shares (Earnings for common reported) | Number | Per share | Number of shares (Adjustment A) | Earned per share (Adjustment A) | Amount (Adjustment B) | Number of Shares (Adjustment B) | Earned per share (Adjustment B) |
|---|---|---|---|---|---|---|---|---|
| 1933 | $2,392 | 1,751 | $1.37 | 1,751 | $1.37 | $3,140 | 2,501 | $1.26 |
| 1932 | 2,491 | 1,751 | 1.42 | 1,751 | 1.42 | 3,240 | 2,501 | 1.30 |
| 1931 | 4,904 | 1,751 | 2.80 | 1,751 | 2.80 | 5,650 | 2,501 | 2.26 |
| 1930 | 5,424 | 1,751 | 3.10 | 1,751 | 3.10 | 6,170 | 2,501 | 2.47 |
| 1929 | 6,621 | 1,657 | 4,00 | 1,741 | 3.80 | 7,370 | 2,491 | 2.95 |
| 1928 | 5,009 | 1,432 | 3.49 | 1,739 | 2.88 | 5,760 | 2,489 | 2.30 |
| 1927 | 3,660 | 1,361 | 2.69 | 1,737 | 2.11 | 4,410 | 2,487 | 2.30 |
| 7-year average | $2.70 | $2.50 | $2.04 |
Corresponding adjustments in book values or current-asset values per share of common stock should be made in analyzing the balance sheet. This technique is followed in our discussion of the Baldwin Locomotive Works exhibit in Appendix Note 70, page 838 on accompanying CD, in which outstanding warrants are allowed for.
In calculating the earnings available for the common, full recognition must be given to the rights of holders of participating issues, whether or not the amounts involved are actually being paid thereon. Similar allowances must be made for the effect of management contracts providing for a substantial percentage of the profits as compensation, as in the case of investment trusts. Unusual cases sometimes arise involving “restricted shares,” dividends on which are contingent upon earnings or other considerations.
Example: Trico Products Corporation, a large manufacturer of automobile accessories, is capitalized at 675,000 shares of common stock, of which 450,000 shares (owned by the president) were originally “restricted” as to dividends. The unrestricted stock is first entitled to dividends of $2.50 per share, after which both classes share equally in further dividends. In addition, successive blocks of the restricted stock were to be released from the restriction according as the earnings for 1925 and successive years reached certain stipulated figures. (To the end of 1938, a total of 239,951 shares had been thus released.)
| Year | Earnings for common | Earned per share on unrestricted stock — A. Ignoring restricted shares | Earned per share on unrestricted stock — B. Maximum distribution on unrestricted shares | Earned per share on unrestricted stock — C. Allowing for release of restricted shares (i.e., on total capitalization) |
|---|---|---|---|---|
| 1929 | $2,250,000 | $6.67 | $4.58 | $3.33 |
| 1930 | 1,908,000 | 5.09 | 3.94 | 2.83 |
| 1931 | 1,763,000 | 4.70 | 3.72 | 2.61 |
| 1932 | 965,000 | 2.57 | 2.54 | 1.44 |
| 1933 | 1.418,000 | 3.78 | 3.21 | 2.10 |
| 1934 | 1,772,000 | 4.72 | 3.74 | 2.62 |
| 1935 | 3,567,000 | 9.84 | 6.52 | 5.38 |
| 1936 | 4,185,000 | 9.75 | 7.25 | 6.39 |
| 1937 | 3,792,000 | 8.97 | 6.82 | 5.99 |
| 1938 | 2,320,000 | 5.56 | 4.53 | 3.70 |
| 10-year average | $3,394,000 | $6.17 | $4.69 | $3.64 |
In the above table Column C supplies the soundest measure of the earning power shown for the unrestricted shares. Column A is irrelevant.
A situation similar to that in Trico Products Corporation obtained in the case of Montana Power Company stock prior to June 1921.
General Rule. The material in the last few pages may be summarized in the in the following general rule:
The intrinsic value of a common stock preceded by convertible securities, or subject to dilution through the exercise of stock options or through participating privileges enjoyed by other security holders, cannot reasonably be appraised at a higher figure than would be justified if all such privileges were exercised in full.