Sudeep commented a long time ago asking where the 8.5 figure comes from in Graham’s formula. You’ll remember that the formula Graham provides in The Intelligent Investor is: Intrinsic Value = Earnings x (8.5 + 2 x growth). Ever since I read the formula I’ve wondered where the 8.5 came from myself, and whether it causes the value to be too high in some cases. Today it finally dawned on me where this comes from and how correct that 8.5 is.
Conceptually, the 8.5 would be the multiple given to a company that has no growth. So Graham felt that a company that currently achieved an earnings of $1 per share and had no prospect for growth would be worth $8.50. Financial math translates this to a perpetuity of current earnings with no growth. The formula for a perpetuity is PV = Cash / discount rate. In the case of the $1 earnings, it would indicate that 8.5 = 1 / discount rate. From here we can solve for the variable, discount rate. The result we get is 11.76%, very near the historical rate of return on equities. So there you have it. I am encouraged by this result and believe it strengthens the case to continue using 8.5 as the factor for a no growth company.
Andrew in Doddsville asked how we weight earnings and growth. We recently made a change to our calculation on growth, which is outlined here. As for earnings, we use a sum of the years digits method to average the last 5 years of earnings with the emphasis on the current period. We believe this allows us to keep the current period at the forefront while smoothing out some of the potential effects of the business cycle.
If you have any questions for us, please go ahead and ask. We’re always interested in helping further the education of our readers (and we like questions because they help us think about things we maybe hadn’t thought of previously) and spread understanding of value investing.