In part one of this two-part series I focused primarily on calculating the intrinsic value (IV) of a common stock based on an analysis and review of historical information and data. Although I strongly believe that there is much that investors can learn by studying the past, I even more strongly believe that since we can only invest in the future, that it is also implicit that we embrace a rational method of forecasting.
Years ago, I expressed my views on the importance of developing a reasonable and rational expectation of the future prospects of a business as follows: we cannot escape the obligation to forecast-our results depend on it. Our forecasts should not be mere prophecy, and we should not simply guess, nor should we play hunches. Instead, we must endeavor to calculate reasonable probabilities based on all factual information that we can assemble. Analytical methods should then be employed based upon our underlying earnings driven rationale, providing us reasons to believe that the relationships producing earnings growth will persist in the future.
Furthermore, I believe that forecasting future earnings is the key to investment success based on my belief and understanding of the undeniable fact that earnings and cash flow determine market price and dividend income in the long run. Not only do I believe that this previous statement is logical, years of observation and personal experience lead me to confidently state that there exists a large volume of historical evidence validating the long-term earnings and price relationship. In short, any business, public or private, derives its value from the amount of cash it is capable of generating on behalf of its stakeholders.
Consequently, I will sum up this introduction by stating that analyzing a stock is best done based on careful consideration and analysis of past, present and future deliberations. More simply stated, I believe we should learn as much as we can from the past, carefully focus on the present (especially on current valuation based on the earnings yield a company currently offers), and finally we must attempt to make rational and reasonable forecasts of what we can expect in the future. Moreover, it is the future prospects of the business that will be most relevant to us, but it is also the most challenging to ascertain.
In my first article of this two-part series I provided numerous discussion points referencing Ben Graham’s thoughts on calculating intrinsic value. Most of my references came from his book The Intelligent Investor, and a few came from his other work Security Analysis. But most importantly I suggested that followers and devotees of Ben Graham should focus more on the underlying principles that made up the foundation of the many timeless lessons that this master offered us, rather than attempting to apply rigid or absolute adherence.
This especially relates to the utilization of any of his mathematical formulas. Ben Graham provided useful mathematical equations that can assist us in calculating a reasonable valuation on certain types of investments. However, the answers produced by his equations should only be thought of as a guide to fair valuation, at least in my humble opinion. In other words, the precise number is not as important as the determination of a reasonable fair value calculation within a reasonable range.
In other words, although I feel I learned a great deal from Ben Graham, I also believe that he never intended anyone to be too zealous with his teachings. I believe an excellent example of overzealousness can be found on the following commentary, the revised edition of The Intelligent Investor presented by Jason Zweig (emphasis added is mine):
“374 Commentary on Chapter 14
Moderate P/E ratio. Graham recommends limiting yourself to stocks whose current price is no more than 15 times average earnings over the past three years. Incredibly, the prevailing practice on Wall Street today is to value stocks by dividing their current price by something called “next year’s earnings.” That gives what is sometimes called “the forward P/E ratio.” But it’s nonsensical to derive a price/earnings ratio by dividing the known current price by unknown future earnings.”
With the above commentary, I contend that Jason Zweig is rigidly inferring that Ben Graham made his intrinsic value calculations solely on historical information. However, I disagree with his assessment, and even more so with the implications that I feel he so disrespectfully expressed regarding his views on today’s prevailing practice of utilizing the forward P/E ratio. I especially object to the use of the word “nonsensical.”
First and foremost, I surmise two things that I believe Ben Graham was trying to accomplish by suggesting that calculating intrinsic value be based on historical information. Number one, I believe that Ben was utilizing the best information that was available to him at the time. Which I might add was prior to the enormous amount of financial data, information and technology available to investors in today’s more modern world.
However, with my second hypothesis I suggest that Ben Graham was utilizing historical information as a basis of a forecast of sorts regarding what he believed the future prospects of the stocks he was considering might be. More simply stated, I don’t believe that Ben Graham was trying to identify businesses that he felt might be awful in the future. Instead, I believe he was using history to help him identify companies that he believed had prospects for an enduring future success. Moreover, I believe that Ben Graham believed in basing his decisions on comprehensive research in order to identify quality undervalued businesses that he could invest in. Implicit in this, at least in my humble opinion, is a view of a bright future for any company he was desirous of investing in.
Jason Zweig then went on to add a discussion where he referenced a commonly cited study conducted by David Dreman and Michael Berry on the accuracy of analyst estimates. In my mind, the implication of this next comment by Jason Zweig was not only designed to discredit the relevance of analyst estimates, it was also implying that basing investment decisions on a forecast of the future was, as he put it, “nonsensical.” Frankly, as I’ve already indicated, I could not disagree more, and I will elaborate on my reasons why later.
“Over the long run, money manager David Dreman has shown, 59% of Wall Street’s “consensus” earnings forecasts miss the mark by a mortifyingly wide margin—either underestimating or overestimating the actual reported earnings by at least 15%.”
Moreover, Jason Zweig also failed to share some additional, and I believe extremely important perspectives that David Dreman also presented in his study regarding analyst estimates. The following quote comes from a paper authored by David Dreman titled Exploiting Behavioral Finance: Portfolio Strategy and Construction, where he eloquently pointed out the challenges of estimating future earnings faced by analysts:
“To the analysts’ credit, they face a difficult environment, with thousands of inputs. Many decisions must be made about how to quantify a company’s earnings estimates. A company may operate in as many as 50 to 100 different countries and have dozens of different products. Company managers, in doing their job properly, do not add to the precision. The analysts’ job is difficult, and expecting them to estimate earnings on the nail every time is not realistic.”
My next David Dreman quote