Security Analysis Series: Chapter 39 Summary

“Price-Earnings Ratios for Common Stocks. Adjustments for Changes in Capitalization”

Chapter Summary

  • The P/E multiple is ultimately a function of public opinion, due to the price aspect of the ratio. Thus an analyst must approach it with a degree of caution in applying it to his analysis. The precise value of an enterprise cannot possibly be formulated by an analyst, due to the constant amount of change that is involved with the company. The P/E multiple itself is but “a matter of purely arbitrary choice” due to the constant changing in aspects related to earnings. (pg 497).
    • “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.” (pg 497).
  • Given this problem of impreciseness, the analyst is limited to three items: (pg 497).
    • A) Set up a basis for “investment valuation” of common stocks;
    • B) Point out the influence of capital structure and sources of income in relation to value;
    • C) Find unusual elements in the balance sheet which affect the implications of earnings.
  • If general business conditions were not exceptionally good, and there exists and upward trend of earnings, and the industry can be expected to continue to grow, an analyst might be able to use the most recent year’s profits might be an accurate portrayal of future earnings. (pg 498).
  • On an investment basis, a P/E ratio of about 20x is “as high a price as can be paid”. (pg 498).
    • While arbitrary, Graham believes that it “is difficult to see how average earnings of less than 5%” can possibly vindicated. There can be virtually no margin of safety in these cases.
    • Graham suggests that a neutral-prospect company might have a P/E ratio of approximately 12. (pg 499).
  • Stocks might be speculative, among other reasons, due to a highly irregular record of earnings, or a high price in relation to earnings. (pg 500).
  • It is appropriate to adjust capitalization for any possible future increases in equity, namely in exercising conversions or warrants. These can seriously hamper upside price potential. It is also important, in these adjustments, to make the changes to book values and asset/liability values in all aspects of the accounting, not just the equity. (pg 504).
  • Graham’s finally word on his general rule:
    • “The intrinsic value of a common stock preceded by convertible securities, or subject to dilution through the exercise of stock options or through participating privileges enjoyed by other security holders, cannot reasonably be appraised at a higher figure than would be justified if all such privileges were exercised in full.” (pg 506).


Chapter Thoughts and Analysis

  • Graham’s quote on the market being a voting machine rather than a weighing machine once again relates to the economic concept of utility in investing. Markets aren’t perfectly efficient, only understanding risk/reward and price. Rather, risk, reward, and price are factors in a holistic equation that can also involve personal bias to a great extent.
  • It seems mostly questionable to simply accept recent year earnings due to normal business conditions, expected industry growth, and upward earnings trends. While I am certain Graham would caveat this acceptance with numerous other quantitative and qualitative factors, it just seems very out of character for him to somewhat make a statement this casual.
  • In a modern context, diluted earnings (earnings where all conversions, warrants, etc. are calculated into equity) are a standard metric, found on all relevant income statements of companies faithful to IFRS.

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