The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [121]
Among industrial bond issues the long-term record has been different. Although the industrial group as a whole has shown a better growth of earning power than either the railroads or the utilities, it has revealed a lesser degree of inherent stability for individual companies and lines of business. Thus in the past, at least, there have been persuasive reasons for confining the purchase of industrial bonds and preferred stocks to companies that not only are of major size but also have shown an ability in the past to withstand a serious depression.
Few defaults of industrial bonds have occurred since 1950, but this fact is attributable in part to the absence of a major depression during this long period. Since 1966 there have been adverse developments in the financial position of many industrial companies. Considerable difficulties have developed as the result of unwise expansion. On the one hand this has involved large additions to both bank loans and long-term debt; on the other it has frequently produced operating losses instead of the expected profits. At the beginning of 1971 it was calculated that in the past seven years the interest payments of all nonfinancial firms had grown from $9.8 billion in 1963 to $26.1 billion in 1970, and that interest payments had taken 29% of the aggregate profits before interest and taxes in 1971, against only 16% in 1963.3 Obviously, the burden on many individual firms had increased much more than this. Overbonded companies have become all too familiar. There is every reason to repeat the caution expressed in our 1965 edition:
We are not quite ready to suggest that the investor may count on an indefinite continuance of this favorable situation, and hence relax his standards of bond selection in the industrial or any other group.
Common-Stock Analysis
The ideal form of common-stock analysis leads to a valuation of the issue which can be compared with the current price to determine whether or not the security is an attractive purchase. This valuation, in turn, would ordinarily be found by estimating the average earnings over a period of years in the future and then multiplying that estimate by an appropriate “capitalization factor.”
The now-standard procedure for estimating future earning power starts with average past data for physical volume, prices received, and operating margin. Future sales in dollars are then projected on the basis of assumptions as to the amount of change in volume and price level over the previous base. These estimates, in turn, are grounded first on general economic forecasts of gross national product, and then on special calculations applicable to the industry and company in question.
An illustration of this method of valuation may be taken from our 1965 edition and brought up to date by adding the sequel. The Value Line, a leading investment service, makes forecasts of future earnings and dividends by the procedure outlined above, and then derives a figure of “price potentiality” (or projected market value) by applying a valuation formula to each issue based largely on certain past relationships. In Table 11-2 we reproduce the projections for 1967–1969 made in June 1964, and compare them with the earnings, and average market price actually realized in 1968 (which approximates the 1967–1969 period).
The combined forecasts proved to be somewhat on the low side, but not seriously so. The corresponding predictions made six years before had turned out to be overoptimistic on earnings and dividends; but this had been offset by use of a low multiplier, with the result that the “price potentiality” figure proved to be about the same as the actual average price for 1963.
The reader will note that quite a number of the