Some Q&A Regarding The Valuation Method
We’ve received a few questions regarding the valuation method we use, which is posted in detail in our post titled “New” Valuation Method. These range from where the 8.5 figure comes from to how we weight earnings. It’s time to tackle some of those questions.
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.
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Well done!
I think you might like my new self-published book. My book, “The Four Filters Invention of Warren Buffett and Charlie Munger” examines each of the basic steps they perform in framing and making an investment decision.
Warren Buffett mentions the Four Filters this way: “Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag.” These Four Filters can enhance the probability of our investment success.
My book is available at http://www.frips.com and, it includes a valuation case example of Kraft, KFT.
Here is a 10 min. audio book summary:
http://www.frips.com/4fsummary.mp3
Ben,
Is there any way that you could take an example and show exactly what numbers you used and how you calculated the valuation? I would like to be able to take this method and use it myself but I want to make sure that I am using the right figures first…
Thanks!
Ben,
I’d also love to see one of these valuations laid out on paper. Im happy to do the work for it, but I dont want to spin my wheels using the wrong numbers!!!
Thanks
James
Why do you not use the formula in Chapter 36 of “Security Analysis” for stock valuations and in what Chapeter of “The Intelligent Investor” is your equation found?