The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [124]
The difference between the implicit 32.4% annual growth rate for Xerox and the extremely modest 2.8% for General Motors is indeed striking. It is explainable in part by the stock market’s feeling that General Motors’ 1963 earnings—the largest for any corporation in history—can be maintained with difficulty and exceeded only modestly at best. The price earnings ratio of Xerox, on the other hand, is quite representative of speculative enthusiasm fastened upon a company of great achievement and perhaps still greater promise.
The implicit or expected growth rate of 5.1% for the DJIA compares with an actual annual increase of 3.4% (compounded) between 1951–1953 and 1961–1963.
We should have added a caution somewhat as follows: The valuations of expected high-growth stocks are necessarily on the low side, if we were to assume these growth rates will actually be realized. In fact, according to the arithmetic, if a company could be assumed to grow at a rate of 8% or more indefinitely in the future its value would be infinite, and no price would be too high to pay for the shares. What the valuer actually does in these cases is to introduce a margin of safety into his calculations—somewhat as an engineer does in his specifications for a structure. On this basis the purchases would realize his assigned objective (in 1963, a future overall return of 7½% per annum) even if the growth rate actually realized proved substantially less than that projected in the formula. Of course, then, if that rate were actually realized the investor would be sure to enjoy a handsome additional return. There is really no way of valuing a high-growth company (with an expected rate above, say, 8% annually), in which the analyst can make realistic assumptions of both the proper multiplier for the current earnings and the expectable multiplier for the future earnings.
As it happened the actual growth for Xerox and IBM proved very close to the high rates implied from our formula. As just explained, this fine showing inevitably produced a large advance in the price of both issues. The growth of the DJIA itself was also about as projected by the 1963 closing market price. But the moderate rate of 5% did not involve the mathematical dilemma of Xerox and IBM. It turned out that the 23% price rise to the end of 1970, plus the 28% in aggregate dividend return received, gave not far from the 7½% annual overall gain posited in our formula. In the case of the other four companies it may suffice to say that their growth did not equal the expectations implied in the 1963 price and that their quotations failed to rise as much as the DJIA. Warning: This material is supplied for illustrative purposes only, and because of the inescapable necessity in security analysis to project the future growth rate for most companies studied. Let the reader not be misled into thinking that such projections have any high degree of reliability or, conversely, that future prices can be counted on to behave accordingly as the prophecies are realized, surpassed, or disappointed.
We should point out that any “scientific,” or at least reasonably dependable, stock evaluation based on anticipated future results must take future interest rates into account. A given schedule of expected earnings, or dividends, would have a smaller present value if we assume a higher than if we assume a lower interest structure.* Such assumptions have always been difficult to make with any degree of confidence, and the recent violent swings in long-term interest rates render forecasts of this sort almost presumptuous. Hence we have retained our old formula above, simply because no new one would appear more plausible.
Industry Analysis
Because the general prospects of the enterprise carry major weight in the establishment of market prices, it is natural for the security analyst to devote a great deal