of tangible assets.”
Warren Buffett
Then once again, Warren Buffett provided the following additional perspective on the necessity of building upon Ben’s foundational concepts as follows:
“Thus our first lesson: businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return. The capitalized value of this excess return is economic goodwill.”
Warren Buffett
However, this section of this article is intended to primarily focus on Ben Graham’s recommendation number 7 “Price no more than fifteen times average earnings of the past three years.” Additional references about the P/E 15 principle were made as the following additional excerpts from the revised edition of The Intelligent Investor reveal:
“Stock Selection for the Defensive Investor 349
6. Moderate Price/Earnings Ratio
Current price should not be more than 15 times average earnings of the past three years.
7. Moderate Ratio of Price to Assets
Current price should not be more than 1 1?2 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5. (This figure corresponds to 15 times earnings and 1 1?2 times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.)”
“350 The Intelligent Investor
The suggested maximum figure of 15 times earnings might well result in a typical portfolio with an average multiplier of, say, 12 to 13 times.”
Clearly, Ben Graham had a strong focus and opinion regarding a P/E ratio of 15 as an important valuation metric. Frankly, I support the concept of the P/E 15 representing fair valuation, or whatever you want to call it, for the majority of publicly-traded companies. Furthermore, I would like to add some additional color and clarity on how and why I believe a PE of 15 is so important and relevant to valuation considerations on common stocks.
First of all, I do not believe it’s a mere coincidence that the 200-year average P/E ratio of the S&P 500 has also been approximately 15. A complete understanding of the P/E ratio as a valuation metric includes the realization that it is also a short form DCF (discounting cash flow) formula in its own right. A P/E ratio of 15 represents an earnings yield of 6.67%. (This calculation is easily made by reversing the numerator and denominator of the P/E ratio to E/P.)
Additionally, a P/E ratio of 15 represents a valuation metric of a current earnings yield that also closely correlates with the long-term rate of return (6% to 8%) that stocks have delivered when valuations were aligned with intrinsic value (P/E 15). Without further elaboration, my contention is that a 6% to 8% return is a rational expectation of what a typical or average company can be expected to generate over the long run. Admittedly, P/E ratio of 15 does not apply to all stocks, but research, observation and long experience have convinced me of the relevance and importance of the P/E ratio of 15 as a valuation guide.
Nevertheless, and as I indicated earlier, the proof is in the pudding. In other words, theories may be great, but can they be applied and tested in real-world circumstances and conditions. My answer is emphatically yes, and it is based on decades of observation and validation on thousands of stocks utilizing the F.A.S.T. Graphs™ research tool. This fundamentals analyzer software tool utilizes Ben Graham’s revised formula cited above when calculating fair valuation on companies growing earnings at 5% or less.
When Ben Graham’s formula is applied this is designated on the graphs with the acronym GDF for Graham Dodd Formula in the color-coded FAST FACTS boxes to the right of each graph. Moreover, for companies growing between 5% and 15%, an extrapolated formula (GDF-PEG) is also used but caps the P/E ratio at 15 based on the logic presented above.
The following earnings and price correlated F.A.S.T. Graphs™ provide evidence utilizing real-life examples of the validity and practical application of Ben Graham’s formula in the real world. As a side note, as the reader reviews these graphs I suggest they also consider that each F.A.S.T. Graphs™essentially provides a clear and graphic back test of the validity of the logic (founded on Ben Graham’s teachings) that they are based on.
Kimberly Clark Corp (NYSE:KMB)
To illustrate how Ben Graham’s formula works in the real world I offer the following series of graphs that correspond with the 7 recommendations from The Intelligent Investor referenced above. Although I will cover all 7, I will not do it in the order listed. My first graph plots Kimberly-Clark’s earnings-per-share (the orange line), clearly validating point number 4: No earnings deficit in the past 10 years.
The graph also validates point number 5: Ten-year growth of at least one third in per-share earnings-as earnings grew from $3.55 per share in 2003 to $5.29 per share in 2012, which is two thirds growth or approximately double Ben’s recommended amount.
The light blue shaded area shows dividends paid, and the pink line plots the same dividends prior to being paid, thereby illustrating the payout ratio. Although not shown on the graph, Kimberly-Clark has paid continuous dividends for more than 20 years meeting Ben’s recommended point number 3:Continued dividends for at least the past 20 years.
Next, by adding monthly closing stock prices to the graph (the black line) we get to undoubtedly see the validity of Ben Graham’s formula at work in the real world. In other words, we see that Ben’s formula works in real life situations. First of all, notice how price tracks the orange earnings line over time (remember the orange line equals a PE of 15 across the entire graph). Also, notice that every time the price deviated either above or below, but especially above the orange line, how it soon comes back into alignment with Ben’s P/E 15 thesis.
The earnings and price relationship relative to a 15 P/E ratio (the orange line) reveals what happened when Kimberly-Clark’s stock price violated Ben’s rule number 7: Price no more than 15 times average earnings of the past 3 years (simply review the last 3 years of earnings and price on the graph – red circle). Each time price was above the orange line visibly indicate less than optimum times to invest in Kimberly-Clark. In other words, the best times to invest in Kimberly-Clark was when its price was at or below the orange 15 P/E ratio line.
From the FAST FACTS box to the right of the graph we see that Kimberly-Clark has a market cap in excess of $37 billion. Straightforwardly, this validates Ben’s point number 1: Adequate size.
The following snapshot of Kimberly-Clark’s balance sheet shows that assets per share (atps) significantly exceed debt long-term per share (dltps), and finally debt per share (dtps). This graph also indicates that most of Kimberly-Clark’s debt is long-term. Taken together, I believe this graph illustrates that Kimberly-Clark meets Ben’s point number 2: A sufficiently strong financial condition.
However, Kimberly-Clark does violate one of Ben Graham’s 7 rules. Kimberly-Clark’s common equity or book value per share (ceqps) of $11.41 during its most recent quarter (MRQ) illustrates the current price is significantly greater than Ben’s rule number 6: Price of stock no more than 1 ½ times net asset value. However, I believe this also speaks to the discussion above regarding valuing intangibles when evaluating modern-day companies. In other words, the 1 ½ times book value principle is not as valid with modern companies as it once was in Ben’s day.
Tompkins Financial Corporation (NYSE:TMP) and Bemis Company, Inc. (NYSE:BMS)
My next two examples are provided as additional evidence of Ben Graham’s 7 recommendations to the defensive investor. I ask that the reader run through both of these examples and apply Ben Graham’s 7 recommendations as I did with Kimberly-Clark.
However, to spare the reader excessive verbosity, I simply offer the graphs on each and allow them to speak for themselves on both examples. But as you review them, remember to do it with the consideration of the 7 recommendations Ben Graham offered, just as I did with the Kimberly-Clark example.
General Mills, Inc. (NYSE:GIS) and VF Corp (NYSE:VFC)
With my next 2 examples, I show how Ben Graham’s principle and views on the importance of the 15 P/E ratio also works for companies that grow earnings above 5%, but below 15% per annum. Even though earnings
