growth rates are higher, the real world relevance of the P/E 15 as an important valuation measurement is crystal clear. Although the slope of the orange earnings growth rate line is higher than 5% in both examples, in both cases we see that the P/E ratio of 15 represents a strong proxy of fair valuation. In other words, notice how price correlates to the orange 15 P/E ratio line.
The Procter & Gamble Company (NYSE:PG)
I have also included an earnings and price correlated graph on Procter & Gamble Company where the orange earnings justified valuation line is also calculated at a P/E of 15. I offer this to point out the reality that there are exceptions to every rule. Ben Graham’s 7 recommendations are no exception to the exception.
Nevertheless, if you clearly studied the graph on Procter & Gamble, you will discover the importance and necessity of also calculating a normal P/E ratio line (the blue line on the graph). Procter & Gamble represents an example of a company that has historically commanded a premium valuation that violates Ben Graham’s recommendations.
On the other hand, it is interesting to note how during the Great Recession that Ben’s important recommendations came into play as Procter & Gamble’s stock price fell to and tracked the orange line for several years following the Great Recession. However, memories are short and Procter & Gamble has once again moved back to its premium valuation level.
Summary and Conclusions
I think it’s important to state that I’m a major fan of Ben Graham and consider him one of my most important mentors. However, it’s also important to recognize that Ben Graham taught some of the most renowned investors that ever walked the planet. A few of the better known are Walter J Schloss, Tom Knapp, William J Ruane, Charlie Munger, Rick Guerin, Stan Perlmeter and finally the most famous of all Warren Buffett. All of these renowned investors were featured in an article by Warren Buffett published in the 1984 issue of Hermes titled The Superinvestors of Graham-and-Doddsville.
However, my reason for mentioning these names is so that I can also point out that without exception they all took the solid foundation that Ben Graham laid and built upon it. Consequently, I suggest that we should focus more on the essence behind the principles that great teachers, like Ben Graham, provided, and less on trying to be too technical or rigid with their application. What Ben Graham was really trying to teach us was the importance of trying to identify fair value and use it to implement sound buy, sell or hold decisions. In other words, I do not believe that Ben expected us to rigidly or fanatically attempt to apply any of his suggestions without simultaneously applying some logical thought and critical thinking behind them.
Moreover, as time marches on our knowledge base grows with each passing moment. Therefore, mankind is constantly building upon and expanding our knowledge base and expanding upon our understanding of important principles in all areas of life. Principles of finance are no exception. In other words, the precise formulas that we use to calculate fair value may change over time, but the underlying principle of investing only when stocks are at fair value or below is timeless.
Therefore, I suggest that we learn the invaluable lessons that great teachers like Ben Graham laid out for us, but at the same time we should be willing and able to apply our expanding knowledge base by building upon the foundations they are supported by.
Finally, we can call it intrinsic value, fundamental value, fair value or true worth and it doesn’t matter. What matters is that we’re making sound and safe investing decisions that are based on reasonable fundamental values. Likewise, we should be smart enough to recognize that any calculations of the concepts relating to the value of the stock or a business can never be perfectly precise. But most importantly, they don’t need to be, they only need to be accurate enough to provide us the opportunity to successfully grow our portfolios and the income they can provide over time. This is especially important for retired investors.
For additional insights into assessing fair value (or whatever you want to call it) I offer links to the following articles I previously wrote on the subject.
How to Know What Rate of Return to Expect from Your Stocks Part 1, Part 2 and Part 3.
In this part one of this two-part series the focus was primarily on looking at historical values. In part 2, I will turn the focus towards the future and the importance of discounting future cash flows (DCF).
Disclosure: Long KMB, GIS and PG at the time of writing.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.
