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Closing Earned P/E

Price Per Share Ratio

a 1963 figures adjusted for distribution of General Motors shares. b 1963 figures adjusted for subsequent stock splits.

2. Management. On Wall Street a great deal is constantly said on this subject, but little that is really helpful. Until objective, quantitative, and reasonably reliable tests of managerial competence are devised and applied, this factor will continue to be looked at through a fog. It is fair to assume that an outstandingly successful company has unusually good management. This will have shown itself already in the past record; it will show up again in the estimates for the next five years, and once more in the previously discussed factor of long-term prospects. The tendency to count it still another time as a separate bullish consideration can easily lead to expensive overvaluations. The management factor is most useful, we think, in those cases in which a recent change has taken place that has not yet had the time to show its significance in the actual figures.

Two spectacular occurrences of this kind were associated with the Chrysler Motor Corporation. The first took place as far back as 1921, when Walter Chrysler took command of the almost moribund Maxwell Motors, and in a few years made it a large and highly profitable enterprise, while numerous other automobile companies were forced out of business. The second happened as recently as 1962, when Chrysler had fallen far from its once high estate and the stock was selling at its lowest price in many years. Then new interests, associated with Consolidation Coal, took over the reins. The earnings advanced from the 1961 figure of $1.24 per share to the equivalent of $17 in 1963, and the price rose from a low of 38/2 in 1962 to the equivalent of nearly 200 the very next year.6

3. Financial Strength and Capital Structure. Stock of a company with a lot of surplus cash and nothing ahead of the common is clearly a better purchase (at the same price) than another one with the same per share earnings but large bank loans and senior securities. Such factors are properly and carefully taken into account by security analysts. A modest amount of bonds or preferred stock, performance of 1) the market as a whole, 2) industry sectors, and 3) specific stocks. As Graham points out, the odds that individual investors can do any better are not good. The intelligent investor excels by making decisions that are not dependent on the accuracy of anybody's forecasts, including his or her own. (See Chapter 8.)

however, is not necessarily a disadvantage to the common, nor is the moderate use of seasonal bank credit. (Incidentally, a top-heavy structure—too little common stock in relation to bonds and preferred—may under favorable conditions make for a huge speculative profit in the common. This is the factor known as "leverage.")

4. Dividend Record. One of the most persuasive tests of high quality is an uninterrupted record of dividend payments going back over many years. We think that a record of continuous dividend payments for the last 20 years or more is an important plus factor in the company's quality rating. Indeed the defensive investor might be justified in limiting his purchases to those meeting this test.

5. Current Dividend Rate. This, our last additional factor, is the most difficult one to deal with in satisfactory fashion. Fortunately, the majority of companies have come to follow what may be called a standard dividend policy. This has meant the distribution of about two-thirds of their average earnings, except that in the recent period of high profits and inflationary demands for more capital the figure has tended to be lower. (In 1969 it was 59.5% for the stocks in the Dow Jones average, and 55% for all American corporations.)* Where the dividend bears a normal relationship to the earnings, the valuation may be made on either basis without substantially affecting the result. For example, a typical secondary company with expected average earnings of $3 and an expected dividend of $2 may be valued at either 12 times its earnings or 18 times its dividend, to yield a value of 36 in both cases.

However, an increasing number of growth companies are departing from the once standard policy of paying out 60% or more of earnings in dividends, on the grounds that the sharehold

* This figure, now known as the "dividend payout ratio," has dropped considerably since Graham's day as American tax law discouraged investors from seeking, and corporations from paying, dividends. As of year-end 2002, the payout ratio stood at 34.1% for the S & P 500-stock index and, as recently as April 2000, it hit an all-time low of just 25.3%. (See www.barra.com/ research/fundamentals.asp.) We discuss dividend policy more thoroughly in the commentary on Chapter 19.

ers' interests will be better served by retaining nearly all the profits to finance expansion. The issue presents problems and requires careful distinctions. We have decided to defer our discussion of the vital question of proper dividend policy to a later section—Chapter 19—where we shall deal with it as a part of the general problem of management-shareholder relations.

Capitalization Rates for Growth Stocks

Most of the writing of security analysts on formal appraisals relates to the valuation of growth stocks. Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the valuation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations. Our formula is:

Value = Current (Normal) Earnings X (8.5 plus twice the expected annual growth rate)

The growth figure should be that expected over the next seven to ten years.7

In Table 11-4 we show how our formula works out for various rates of assumed growth. It is easy to make the converse calculation and to determine what rate of growth is anticipated by the current market price, assuming our formula is valid. In our last edition we made that calculation for the DJIA and for six important stock issues. These figures are reproduced in Table 11-5. We commented at the time:

The difference between the implicit 32.4% annual growth rate for Xerox and the extremely modest 2.8% for General Motors is indeed striking. It is explainable in part by the stock market's feeling that General Motors' 1963 earnings—the largest for any corporation in history—can be maintained with difficulty and exceeded only modestly at best. The price earnings ratio of Xerox, on the other hand, is quite representative of speculative enthusiasm fastened upon a company of great achievement and perhaps still greater promise.

The implicit or expected growth rate of 5.1% for the DJIA com-

TABLE 11-4 Annual Earnings Multipliers Based

on Expected Growth Rates,

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