The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [134]
Calculation of the Past Growth Rate
It is of prime importance that the growth factor in a company’s record be taken adequately into account. Where the growth has been large the recent earnings will be well above the seven-or ten-year average, and analysts may deem these long-term figures irrelevant. This need not be the case. The earnings can be given in terms both of the average and the latest figure. We suggest that the growth rate itself be calculated by comparing the average of the last three years with corresponding figures ten years earlier. (Where there is a problem of “special charges or credits” it may be dealt with on some compromise basis.) Note the following calculation for the growth of ALCOA as against that of Sears Roebuck and the DJIA group as a whole.
Comment: These few figures could be made the subject of a long discussion. They probably show as well as any others, derived by elaborate mathematical treatment, the actual growth of earnings for the long period 1958–1970. But how relevant is this figure, generally considered central in common-stock valuations, to the case of ALCOA? Its past growth rate was excellent, actually a bit better than that of acclaimed Sears Roebuck and much higher than that of the DJIA composite. But the market price at the beginning of 1971 seemed to pay no attention to this fine performance. ALCOA sold at only 11½ times the recent three-year average, while Sears sold at 27 times and the DJIA itself at 15+ times. How did this come about? Evidently Wall Street has fairly pessimistic views about the future course of ALCOA’s earnings, in contrast with its past record. Surprisingly enough, the high price for ALCOA was made as far back as 1959. In that year it sold at 116, or 45 times its earnings. (This compares with a 1959 adjusted high price of 25½ for Sears Roebuck, or 20 times its then earnings.) Even though ALCOA’s profits did show excellent growth thereafter, it is evident that in this case the future possibilities were greatly overestimated in the market price. It closed 1970 at exactly half of the 1959 high, while Sears tripled in price and the DJIA moved up nearly 30%.
TABLE 12-1
It should be pointed out that ALCOA’s earnings on capital funds* had been only average or less, and this may be the decisive factor here. High multipliers have been maintained in the stock market only if the company has maintained better than average profitability.
Let us apply at this point to ALCOA the suggestion we made in the previous chapter for a “two-part appraisal process.”* Such an approach might have produced a “past-performance value” for ALCOA of 10% of the DJIA, or $84 per share relative to the closing price of 840 for the DJIA in 1970. On this basis the shares would have appeared quite attractive at their price of 57¼.
To what extent should the senior analyst have marked down the “past-performance value” to allow for adverse developments that he saw in the future? Frankly, we have no idea. Assume he had reason to believe that the 1971 earnings would be as low as $2.50 per share—a large drop from the 1970 figure, as against an advance expected for the DJIA. Very likely the stock market would take this poor performance quite seriously, but would it really establish the once mighty Aluminum Company of America as a relatively unprofitable enterprise, to be valued at less than its tangible assets behind the shares?† (In 1971 the price declined from a high of 70 in May to a low of 36 in December, against a book value of 55.)
ALCOA is surely a representative industrial company of huge size, but we think that its price-and-earnings history is more unusual, even contradictory, than that of most other large enterprises. Yet this instance supports to some degree, the doubts we expressed in the last chapter as to the dependability of the appraisal procedure when applied to the typical industrial company.
Commentary