Saturday, September 23, 2006

Important Points form Graham and Dodd - Part V


Page 516

Intuition Not a Part of the Analyst’s Stock in Trade.-In the absence of indications to the contrary we accept the past record as a basis for judging the future. But analyst must be on the lookout for any such indications to the contrary.

The ability to see what is coming is of inestimable value, but it cannot be expected to be part of the analyst’s stock in trade.

He can be asked to show only that moderate degree of foresight which springs from logic and form experience intelligently pondered.

Analysis of the Future Should be Penetrating Rather than Prophetic.-Analytical reasoning with regard to the future is of a somewhat different character, being penetrating rather than prophetic.

Page 530

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 part on the prevailing psychology and partly on the nature and record of the enterprise.

Page 531

Exact Appraisal Impossible.-Security analysis cannot presume to lay down general rules as to the “proper value” of any given common stock. Parctically 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.

But the stock market itself has no time for such scientific scruples. It must make its value first and find its reasons afterwards.

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 Analyst 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 judgment 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.

Page 531

A Suggested Basis of Maximum Appraisal for Investment.- …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 earnings for some years past and (3) the investor’s study of the industry gives him confidence in its continued growth.

In 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 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.

Page 533

We must emphasize also that a reasonable ratio 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.

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