Every investor in common stocks is faced with the challenge of knowing when to buy, sell or hold. Additionally, this challenge will be approached differently by the true investor than it would by a speculator. But since I know very little about speculation (trading or market timing), this article will be focused on assisting true investors desirous of a sound and reliable method that they can trust and implement when attempting to make these important buy, sell or hold investing decisions.
Furthermore, it logically follows that true investing requires a diligent focus and comprehensive understanding of the true worth of any business under consideration. This last notion logically extends to a second notion implying that true investors are also value investors, at least on some level. Consequently, it further highlights the importance of having at least a reasonable idea of what any business you own, or are contemplating owning in the future, is worth in order to successfully invest over the long term.
However, there is an additional layer of complexity that applies to the concept of identifying the true worth of a business. Within the jargon of Wall Street there are many expressions of true worth that are bantered about that are often vague and imprecisely thrown about. For example, when attempting to quantify the value of a business, the four most common expressions will be intrinsic value, fair value, fundamental value and true worth. In truth, these are not synonyms, but often utilized as if they were. Nevertheless, all four share a common objective.
Whether you call it intrinsic value, fair value, fundamental value or true worth, the idea is to quantify optimum prices (valuation levels), which make the most sense regarding making sound decisions to buy, sell or hold a given stock. And even though they are not exact synonyms, they are all close enough to be of practical value. In other words, all four of these expressions of valuation are focused on calculating and knowing what the business you own is actually worth (within a reasonable range), so that your decisions can be sound and beneficial to your long-term performance. Therefore, semantics aside, it all comes down to having an intelligent framework in order to accurately make sound long-term investing decisions.
Therefore, even though I believe it is both useful and important to attempt to try and apply some precision to the definitions regarding true worth, intrinsic value, fundamental value or fair value, investing need not be a game of perfect. Consequently, at their essence, and in regards to making successful investing decisions, they are all concepts that can be used to identify the value of a business. However, there are differences and even nuances that each imply in its own right. On the other hand, the real test supporting any of them is whether or not they can be utilized in real-world applications. I will cover this last point more extensively later in the article.
Intrinsic Value
In my opinion, one of the mistakes that many investors make when attempting to calculate intrinsic value is that they are too strict or rigid with the application of the various mathematical formulas suggested. The following table calculates the intrinsic value of 10 Standard & Poor’s Dividend Aristocrats with the highest premium of current price versus the formulaic calculation of intrinsic value.
These calculations were made using a popular intrinsic value calculator that will remain unidentified. The point I am attempting to make with this table is that relying on the strictest use of the mathematical formula (Ben Graham’s formula) embraced by many, provides an intrinsic value number that is completely impractical in real world applications.
My point being that none of these Dividend Aristocrats could ever be purchased at the calculated intrinsic value price. More simply stated, if you rigidly waited for intrinsic value to manifest on this basis, you would never own any of these names.
Ben Graham’s Formulas For Calculating Intrinsic Value
The concept of intrinsic value is most often associated with the legendary and widely considered father of value investing, Ben Graham. In addition to referencing the term “intrinsic value” numerous times in his seminal work The Intelligent Investor, Ben Graham is also credited with proposing his famous Ben Graham formula for calculating intrinsic value. The formula described by Ben Graham in the 1962 edition of Security Analysis is as follows:
V = Intrinsic Value
EPS = Trailing Twelve Months Earnings Per Share
8.5 = P/E base for a no-growth company
g = reasonably expected 7 to 10 year growth rate
EPS = Trailing Twelve Months Earnings Per Share
8.5 = P/E base for a no-growth company
g = reasonably expected 7 to 10 year growth rate
In 1974, Ben Graham revised his formula in order to more accurately account for changes in interest rates. What’s important to recognize here, is that Ben Graham’s approach to calculating intrinsic value evolved, as his knowledge and experience also evolved. Ben’s revised (1974 ) intrinsic value formula is as follows:
V: Intrinsic Value
EPS: the company’s last 12-month earnings per share
8.5: the constant represents the appropriate P-E ratio for a no-growth company as proposed by Graham
g: the company’s long-term (five years) earnings growth estimate
4.4: the average yield of high-grade corporate bonds in 1962, when this model was introduced
Y: the current yield on AAA corporate bonds
EPS: the company’s last 12-month earnings per share
8.5: the constant represents the appropriate P-E ratio for a no-growth company as proposed by Graham
g: the company’s long-term (five years) earnings growth estimate
4.4: the average yield of high-grade corporate bonds in 1962, when this model was introduced
Y: the current yield on AAA corporate bonds
The following article I authored on February 11, 2011 provides my first real-world evidence of Ben Graham’s formula at work. (Note that the F.A.S.T. Graphs™ research tool applies Ben’s classic formula on companies when earnings growth is 5% or less, this is an important and necessary adjustment, as I will discuss in greater detail below.)
Ben Graham’s View of the P/E Ratio 15
Of course, there was a lot more behind Ben Graham’s work than relying on a formula. Ben believed in and practiced comprehensive fundamental research analysis. Moreover, he shared his concepts and beliefs extensively through his books, the most famous of which is The Intelligent Investor.
The following excerpt found on pages 337 and 338 summarizes his 7 recommendations to what he referred to as the defensive investor. However, it is also important to recognize two important points. Number one, these were offered as recommendations to conservative (defensive) investors, but not as absolutes. Point number two, the reader should also consider that Ben Graham developed these recommendations when America was primarily an industrial economy prior to evolving into today’s more prevalent service-based economy. Ben’s 7 recommendations are as follows:
“These will be developed in the next chapter, but we summarize them as follows:
1. Adequate size.
2. A sufficiently strong financial condition.
3. Continued dividends for at least the past 20 years.
4. No earnings deficit in the past ten years.
5. Ten-year growth of at least one-third in per-share earnings.
(*Note: my calculations suggest that this implies a minimum of approximately 3% earnings growth.)
6. Price of stock no more than 1 1⁄2 times net asset value.
7. Price no more than 15 times average earnings of the past three years.” (Emphasis mine.)
Consequently, most of the businesses that Ben Graham was originally evaluating were rich in tangible assets. Therefore, his recommendation number 6 was more appropriate for tangible assets-based corporations, but less so for companies operating in today’s service-based economy where many companies’ balance sheets also include significant levels of intangible assets. (Note: this is one reason that the above intrinsic value calculator table produced such impractical intrinsic value results.)
Applying a precise calculation of the value of intangible assets such as intellectual property and goodwill is much more challenging than valuing a building or piece of equipment, etc. However, I feel it’s important to interject here that a business derives its value from the amount of cash flow it is capable of generating on behalf of its stakeholders. Intangible assets, like tangible assets, can and do produce significant cash flows for many service and technologically-based companies. Therefore, even though they are more difficult to accurately value, they do produce true economic value.
The point I’m trying to make is that I believe Ben Graham laid a solid foundation for rational approaches to valuing a business. However, I also recognize and believe that it is incumbent upon his devotees and followers to build upon the foundation that Ben laid. His most famous student, Warren Buffett, provides some perspective on this hypothesis as follows:
“You can have a full and rewarding life without ever thinking about goodwill and it’s amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic goodwill. This bias caused me to make many important business mistakes of omission although relatively few of commission. Keynes identified my problem ‘The difficulty lies not in the new ideas but in escaping from the old ones.’ My escape was long delayed, in part because most of what I had been taught by the same teacher had been (and continues to be) so extraordinarily valuable. Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring goodwill and that utilize a minimum of tangible assets.”
Warren Buffett
Warren Buffett
Then once again, Warren Buffett provided the following additional perspective on the necessity of building upon Ben’s foundational concepts as follows:
“Thus our first lesson: businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic goodwill.”
Warren Buffett
Warren Buffett
However, this section of this article is intended to primarily focus on Ben Graham’s recommendation number 7 “Price no more than fifteen times average earnings of the past three years.” Additional references about the P/E 15 principle were made as the following additional excerpts from the revised edition of The Intelligent Investor reveal:
“Stock Selection for the Defensive Investor 349
6. Moderate Price/Earnings Ratio
Current price should not be more than 15 times average earnings of the past three years.
7. Moderate Ratio of Price to Assets
Current price should not be more than 1 1⁄2 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5. (This figure corresponds to 15 times earnings and 1 1⁄2 times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.)”
“350 The Intelligent Investor
The suggested maximum figure of 15 times earnings might well result in a typical portfolio with an average multiplier of, say, 12 to 13 times.”
Clearly, Ben Graham had a strong focus and opinion regarding a P/E ratio of 15 as an important valuation metric. Frankly, I support the concept of the P/E 15 representing fair valuation, or whatever you want to call it, for the majority of publicly-traded companies. Furthermore, I would like to add some additional color and clarity on how and why I believe a PE of 15 is so important and relevant to valuation considerations on common stocks.
First of all, I do not believe it’s a mere coincidence that the 200-year average P/E ratio of the S&P 500 has also been approximately 15. A complete understanding of the P/E ratio as a valuation metric includes the realization that it is also a short form DCF (discounting cash flow) formula in its own right. A P/E ratio of 15 represents an earnings yield of 6.67%. (This calculation is easily made by reversing the numerator and denominator of the P/E ratio to E/P.)
Additionally, a P/E ratio of 15 represents a valuation metric of a current earnings yield that also closely correlates with the long-term rate of return (6% to 8%) that stocks have delivered when valuations were aligned with intrinsic value (P/E 15). Without further elaboration, my contention is that a 6% to 8% return is a rational expectation of what a typical or average company can be expected to generate over the long run. Admittedly, P/E ratio of 15 does not apply to all stocks, but research, observation and long experience have convinced me of the relevance and importance of the P/E ratio of 15 as a valuation guide.
Nevertheless, and as I indicated earlier, the proof is in the pudding. In other words, theories may be great, but can they be applied and tested in real-world circumstances and conditions. My answer is emphatically yes, and it is based on decades of observation and validation on thousands of stocks utilizing the F.A.S.T. Graphs™ research tool. This fundamentals analyzer software tool utilizes Ben Graham’s revised formula cited above when calculating fair valuation on companies growing earnings at 5% or less.
When Ben Graham’s formula is applied this is designated on the graphs with the acronym GDF for Graham Dodd Formula in the color-coded FAST FACTS boxes to the right of each graph. Moreover, for companies growing between 5% and 15%, an extrapolated formula (GDF-PEG) is also used but caps the P/E ratio at 15 based on the logic presented above.
The following earnings and price correlated F.A.S.T. Graphs™ provide evidence utilizing real-life examples of the validity and practical application of Ben Graham’s formula in the real world. As a side note, as the reader reviews these graphs I suggest they also consider that each F.A.S.T. Graphs™ essentially provides a clear and graphic back test of the validity of the logic (founded on Ben Graham’s teachings) that they are based on.
Kimberly-Clark Corp. (KMB)
To illustrate how Ben Graham’s formula works in the real world I offer the following series of graphs that correspond with the 7 recommendations from The Intelligent Investor referenced above. Although I will cover all 7, I will not do it in the order listed. My first graph plots Kimberly-Clark’s earnings-per-share (the orange line), clearly validating point number 4: No earnings deficit in the past 10 years.
The graph also validates point number 5: Ten-year growth of at least one third in per-share earnings-as earnings grew from $3.55 per share in 2003 to $5.29 per share in 2012, which is two thirds growth or approximately double Ben’s recommended amount.
The light blue shaded area shows dividends paid, and the pink line plots the same dividends prior to being paid, thereby illustrating the payout ratio. Although not shown on the graph, Kimberly-Clark has paid continuous dividends for more than 20 years meeting Ben’s recommended point number 3: Continued dividends for at least the past 20 years.
Next, by adding monthly closing stock prices to the graph (the black line) we get to undoubtedly see the validity of Ben Graham’s formula at work in the real world. In other words, we see that Ben’s formula works in real life situations. First of all, notice how price tracks the orange earnings line over time (remember the orange line equals a PE of 15 across the entire graph). Also, notice that every time the price deviated either above or below, but especially above the orange line, how it soon comes back into alignment with Ben’s P/E 15 thesis.
The earnings and price relationship relative to a 15 P/E ratio (the orange line) reveals what happened when Kimberly-Clark’s stock price violated Ben’s rule number 7: Price no more than 15 times average earnings of the past 3 years (simply review the last 3 years of earnings and price on the graph – red circle). Each time price was above the orange line visibly indicate less than optimum times to invest in Kimberly-Clark. In other words, the best times to invest in Kimberly-Clark was when its price was at or below the orange 15 P/E ratio line.
From the FAST FACTS box to the right of the graph we see that Kimberly-Clark has a market cap in excess of $37 billion. Straightforwardly, this validates Ben’s point number 1: Adequate size.
The following snapshot of Kimberly-Clark’s balance sheet shows that assets per share (atps) significantly exceed debt long-term per share (dltps), and finally debt per share (dtps). This graph also indicates that most of Kimberly-Clark’s debt is long-term. Taken together, I believe this graph illustrates that Kimberly-Clark meets Ben’s point number 2: A sufficiently strong financial condition.
However, Kimberly-Clark does violate one of Ben Graham’s 7 rules. Kimberly-Clark’s common equity or book value per share (ceqps) of $11.41 during its most recent quarter (MRQ) illustrates the current price is significantly greater than Ben’s rule number 6: Price of stock no more than 1 ½ times net asset value. However, I believe this also speaks to the discussion above regarding valuing intangibles when evaluating modern-day companies. In other words, the 1 ½ times book value principle is not as valid with modern companies as it once was in Ben’s day.
Tompkins Financial Corp. (TMP) and Bemis Company Inc. (BMS)
My next two examples are provided as additional evidence of Ben Graham’s 7 recommendations to the defensive investor. I ask that the reader run through both of these examples and apply Ben Graham’s 7 recommendations as I did with Kimberly-Clark.
However, to spare the reader excessive verbosity, I simply offer the graphs on each and allow them to speak for themselves on both examples. But as you review them, remember to do it with the consideration of the 7 recommendations Ben Graham offered, just as I did with the Kimberly-Clark example.
General Mills Inc. (GIS) and VF Corp. (VFC)
With my next 2 examples, I show how Ben Graham’s principle and views on the importance of the 15 P/E ratio also works for companies that grow earnings above 5%, but below 15% per annum. Even though earnings growth rates are higher, the real world relevance of the P/E 15 as an important valuation measurement is crystal clear. Although the slope of the orange earnings growth rate line is higher than 5% in both examples, in both cases we see that the P/E ratio of 15 represents a strong proxy of fair valuation. In other words, notice how price correlates to the orange 15 P/E ratio line.
Procter & Gamble Company (PG)
I have also included an earnings and price correlated graph on Procter & Gamble Company where the orange earnings justified valuation line is also calculated at a P/E of 15. I offer this to point out the reality that there are exceptions to every rule. Ben Graham’s 7 recommendations are no exception to the exception.
Nevertheless, if you clearly studied the graph on Procter & Gamble, you will discover the importance and necessity of also calculating a normal P/E ratio line (the blue line on the graph). Procter & Gamble represents an example of a company that has historically commanded a premium valuation that violates Ben Graham’s recommendations.
On the other hand, it is interesting to note how during the Great Recession that Ben’s important recommendations came into play as Procter & Gamble’s stock price fell to and tracked the orange line for several years following the Great Recession. However, memories are short and Procter & Gamble has once again moved back to its premium valuation level.
Summary and Conclusions
I think it’s important to state that I’m a major fan of Ben Graham and consider him one of my most important mentors. However, it’s also important to recognize that Ben Graham taught some of the most renowned investors that ever walked the planet. A few of the better known are Walter J Schloss, Tom Knapp, William J Ruane, Charlie Munger, Rick Guerin, Stan Perlmeter and finally the most famous of all Warren Buffett. All of these renowned investors were featured in an article by Warren Buffett published in the 1984 issue of Hermes titled The Superinvestors of Graham-and-Doddsville.
However, my reason for mentioning these names is so that I can also point out that without exception they all took the solid foundation that Ben Graham laid and built upon it. Consequently, I suggest that we should focus more on the essence behind the principles that great teachers, like Ben Graham, provided, and less on trying to be too technical or rigid with their application. What Ben Graham was really trying to teach us was the importance of trying to identify fair value and use it to implement sound buy, sell or hold decisions. In other words, I do not believe that Ben expected us to rigidly or fanatically attempt to apply any of his suggestions without simultaneously applying some logical thought and critical thinking behind them.
Moreover, as time marches on our knowledge base grows with each passing moment. Therefore, mankind is constantly building upon and expanding our knowledge base and expanding upon our understanding of important principles in all areas of life. Principles of finance are no exception. In other words, the precise formulas that we use to calculate fair value may change over time, but the underlying principle of investing only when stocks are at fair value or below is timeless.
Therefore, I suggest that we learn the invaluable lessons that great teachers like Ben Graham laid out for us, but at the same time we should be willing and able to apply our expanding knowledge base by building upon the foundations they are supported by.
Finally, we can call it intrinsic value, fundamental value, fair value or true worth and it doesn’t matter. What matters is that we’re making sound and safe investing decisions that are based on reasonable fundamental values. Likewise, we should be smart enough to recognize that any calculations of the concepts relating to the value of the stock or a business can never be perfectly precise. But most importantly, they don’t need to be, they only need to be accurate enough to provide us the opportunity to successfully grow our portfolios and the income they can provide over time. This is especially important for retired investors.
For additional insights into assessing fair value (or whatever you want to call it) I offer links to the following articles I previously wrote on the subject.
In this part one of this two-part series the focus was primarily on looking at historical values. In part 2, I will turn the focus towards the future and the importance of discounting future cash flows (DCF).
Disclosure: Long KMB, GIS and PG at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation. This article was written by Chuck Carnevale. If you enjoyed this article, you can read more of his articles here.
