The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [151]
Earnings growth. How many companies in the S & P 500 increased their earnings per share by “at least one third,” as Graham requires, over the 10 years ending in 2002? (We’ll average each company’s earnings from 1991 through 1993, and then determine whether the average earnings from 2000 through 2002 were at least 33% higher.) According to Morgan Stanley, 264 companies in the S & P 500 met that test. But here, it seems, Graham set a very low hurdle; 33% cumulative growth over a decade is less than a 3% average annual increase. Cumulative growth in earnings per share of at least 50%—or a 4% average annual rise—is a bit less conservative. No fewer than 245 companies in the S & P 500 index met that criterion as of early 2003, leaving the defensive investor an ample list to choose from. (If you double the cumulative growth hurdle to 100%, or 7% average annual growth, then 198 companies make the cutoff.)
FIGURE 14-2 Steady Eddies
Source: Standard & Poor’s Corp.
Data as of 12/31/2002.
Moderate P/E ratio. Graham recommends limiting yourself to stocks whose current price is no more than 15 times average earnings over the past three years. Incredibly, the prevailing practice on Wall Street today is to value stocks by dividing their current price by something called “next year’s earnings.” That gives what is sometimes called “the forward P/E ratio.” But it’s nonsensical to derive a price/earnings ratio by dividing the known current price by unknown future earnings. Over the long run, money manager David Dreman has shown, 59% of Wall Street’s “consensus” earnings forecasts miss the mark by a mortifyingly wide margin—either underestimating or overestimating the actual reported earnings by at least 15%.2 Investing your money on the basis of what these myopic soothsayers predict for the coming year is as risky as volunteering to hold up the bulls-eye at an archery tournament for the legally blind. Instead, calculate a stock’s price/earnings ratio yourself, using Graham’s formula of current price divided by average earnings over the past three years.3
As of early 2003, how many stocks in the Standard & Poor’s 500 index were valued at no more than 15 times their average earnings of 2000 through 2002? According to Morgan Stanley, a generous total of 185 companies passed Graham’s test.
Moderate price-to-book ratio. Graham recommends a “ratio of price to assets” (or price-to-book-value ratio) of no more than 1.5. In recent years, an increasing proportion of the value of companies has come from intangible assets like franchises, brand names, and patents and trademarks. Since these factors (along with goodwill from acquisitions) are excluded from the standard definition of book value, most companies today are priced at higher price-to-book multiples than in Graham’s day. According to Morgan Stanley, 123 of the companies in the S & P 500 (or one in four) are priced below 1.5 times book value. All told, 273 companies (or 55% of the index) have price-to-book ratios of less than 2.5.
What about Graham’s suggestion that you multiply the P/E ratio by the price-to-book ratio and see whether the resulting number is below 22.5? Based on data from Morgan Stanley, at least 142 stocks in the S & P 500 could pass that test as of early 2003, including Dana Corp., Electronic Data Systems, Sun Microsystems, and Washington Mutual. So Graham’s “blended multiplier” still works as an initial screen to identify reasonably-priced stocks.
Due Diligence
No matter how defensive an investor you are—in Graham’s sense of wishing to minimize the work you put into picking stocks—there are a couple of steps you cannot afford to skip:
Do your homework. Through the EDGAR database at www.sec. gov, you get instant access to a company’s annual and quarterly reports, along with the proxy statement that discloses the managers’ compensation, ownership, and potential conflicts of interest. Read