Personal finance

A Suggested Basis of Maximum Appraisal for Investment. The investor in common stocks, equally with the speculator, is dependent on future rather than past earnings. His fundamental basis of appraisal must be an intelligent and conservative estimate of the future earning power. But his measure of future earnings can be conservative only if it is limited by actual performance over a period of time. We have suggested, however, that 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 of earnings for some years past and (3) the investor’s study of the industry gives him confidence in its continued growth. In a 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 must 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.

Although this rule is of necessity arbitrary in its nature, it is not entirely so. Investment presupposes demonstrable value, and the typical common stock’s value can be demonstrated only by means of an established, i.e., an average, earning power. But it is difficult to see how average earnings of less than 5% upon the market price could ever be considered as vindicating that price. Clearly such a price-earnings ratio could not provide that margin of safety which we have associated with the investor’s position. It might be accepted by a purchaser in the expectation that future earnings will be larger than in the past. But in the original and most useful sense of the term such a basis of valuation is speculative. It falls outside the purview of common-stock investment.

Higher Prices May Prevail for Speculative Commitments. The intent of this distinction must be clearly understood. We do not imply that it is a mistake to pay more than 20 times average earnings for any common stock. We do suggest that such a price would be speculative. The purchase may easily turn out to be highly profitable, but in that case it will have proved a wise or fortunate speculation. It is proper to remark, moreover, that very few people are consistently wise or fortunate in their speculative operations. Hence we may submit, as a corollary of no small practical importance, that people who habitually purchase common stocks at more than about 20 times their average earnings are likely to lose considerable money in the long run. This is the more probable because, in the absence of such a mechanical check, they are prone to succumb recurrently to the lure of bull markets, which always find some specious argument to justify paying extravagant prices for common stocks.

Other Requisites for Common Stocks of Investment Grade and a Corollary Therefrom. It should be pointed out that if 20 times average earnings is taken as the upper limit of price for an investment purchase, then ordinarily the price paid should be substantially less than this maximum. This suggests that about 12 or 12½ times average earnings may be suitable for the typical case of a company with neutral prospects. We must emphasize also that a reasonable ratio of 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.

From this principle there follows another important corollary, viz.: An attractive common-stock investment is an attractive speculation. This is true because, if a common stock can meet the demand of a conservative investor that he get full value for his money plus not unsatisfactory future prospects, then such an issue must also have a fair chance of appreciating in market value.

There is no reason at all for thinking that the average intelligent investor, even with much devoted effort, can derive better results over the years from the purchase of growth stocks than the investment companies specializing in this area. Surely these organizations have more brains and better research facilities at their disposal than you do. Consequently we should advise against the usual type of growth-stock commitment for the enterprising investor. This is one in which the excellent prospects are fully recognized in the market and already reflected in a current price-earnings ratio of, say, higher than 20. (For the defensive investor we suggested an upper limit of purchase price at 25 times average earnings of the past seven years. The two criteria would be about equivalent in most cases.)