Aurora Borealis
1 January 1995 Financial Analysts Journal Volume 51, Issue 1

Two Illustrative Approaches to Formula Valuations of Common Stocks

  1. Benjamin Graham

The widely accepted method of valuation is to estimate the average earnings and dividends for a period of years into the future and capitalize these elements at an appropriate rate. The trick is choosing a growth factor for the company. This article explores two approaches to finding the multiplier of past earnings. In the first, the analyst derives an independent value to compare with the market price. In this study, the valuations took into account four historical elements—profitability, growth, stability, and dividend payout—which were applied as multipliers to average earnings for 1947-1956 (plus a 20 percent weight given to net asset value). Values of 30 DJIA stocks were compared with the value in 1957 of the DJIA and its average market level for the preceding 12 months. From this approach, prices were derived. The second approach is the reverse of the first: It starts with market price and calculates from it the rate of future growth expected by the market, from which expected future earnings are derived. I found that a discrepancy exists between values derived in the first approach and values the market is assigning through prices. I draw the following conclusions: Formula valuations derived in the first approach are not useful for predicting the future, primarily because the market often has ideas of future earnings that cannot be derived from company past performance. Formula valuations are useful in showing what the future would be if it were merely a continuation of the past; the analyst must then apply knowledge and investigation to understand the discrepancy. The second approach concentrates the analyst's attention on market expectations, and again, the analyst must apply knowledge and investigation to decide whether to accept the market's thinking or take issue with it. The valuation method provides a point of reference for this decision.

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