This post has been about 2 weeks in the making. A couple of weeks ago, we were asked in a comment if we could elaborate a little on our valuation process. We had been using a complex mathematical formula and system to determine value that took into account a number of different approaches. As the system was difficult to explain, we always had a stance that we would not discuss the details of how we came about our intrinsic value numbers. However, when I was thinking about how to respond to the latest question, I also began to wonder if we could find something that was easier to explain.
I was led back to Graham’s The Intelligent Investor, where I found a formula that I had originally passed over as it is in a section that refers to “Growth” stocks. The first couple of times I read the book I thought of the formula as a way to look at high growth stocks, but this time, I saw it differently. If it worked for Graham with growth stocks, why couldn’t it be tweaked in order to work for all companies? I then set to work on “modernizing” Graham’s original formula.
Here is the text from The Intelligent Investor that includes the formula (found on page 295 of 2006 updated edition – chapter 11):
“Most of the writing of security analysts on formal appraisals relates to the valuation of growth stocks. Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the valuation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations. Our formula is:
Value = Current (Normal) Earnings X (8.5 plus twice the expected annual growth rate)
The growth figure should be that expected over the next seven to ten years.” (A footnote then explains that the formula does not give the “true value” but approximates)
So Graham provides us with a base formula to approximate value. The next step was to find the correct figures to input into the formula. You’ll notice that Graham has specified that we should use “normal” earnings in this calculation. This is one of the most important things that Graham teaches – do not base your judgment on current period earnings that could be abnormally inflated or deflated. Instead, base your judgment on the earnings that the company has normally achieved and can be expected to achieve in the future.
But how do you get normal earnings in a simple manner? One of the things we at ModernGraham have done since the beginning is use a weighted average of the last 5 years’ earnings per share. We use a weighted average because we do feel that some bearing must be placed on the current period even if it is an abnormal result. Accordingly, our average increases in weight each year. We refer to this weighted average earnings per share as the EPSmg.
From there, the next question is where do you get a growth rate for the next seven to ten years? You can do that a number of ways. One, you can find an analyst forecast and plug their rate in. We don’t like to trust analysts because they are almost always wrong and they can hardly ever agree. Instead, we calculate our own expected growth rate using a weighted average on the previous 5 years again. Then we throw in one of our safety screens by multiplying the average by 0.75 (effectively decreasing it by approximately 25%). Sometimes this still gives us an outrageous figure. As a result, we limit our growth rate to a level between -4% and 15% per year. We feel that any company that is expected to shrink by more than 4% per year is unsuitable for investment anyway, and no company should be expected to achieve higher than 15% growth for seven to ten years. That’s not to say higher than 15% growth may be achieved – it can and it has been by a lot of high growth companies – but we do not want to put ourselves at risk of it not being done. If we put the cap at 15% and still find the company to be undervalued, then our results will be even greater when a higher rate is actually achieved.
You’ll notice that there are a couple of implications that result from our cap of the growth rate. One, it means that we feel a zero-growth company would be worth at least 8.5 times normal earnings. This is the same as what Graham felt and could be a result of an approximation of the present value of a perpetuity of the normal earnings. Two, the cap means that we do not feel comfortable paying more than 38.5 times normal earnings. In fact, we do not feel comfortable for the defensive investor at more than 20 times normal earnings.
After “modernizing” Graham’s original formula, I then set about testing the results of following it. In order to do this easily, I made a couple of assumptions:
- I looked only at the current 30 components of the Dow Jones Industrial Average.
- I did not consider whether the companies passed the defensive and enterprising investor guidelines we require.
With the assumptions made, I came up with a valuation for each company on a quarterly basis going back to the first quarter of 1995. I then looked at the company each quarter to compare the price to the value. If the price was below 75% of the value determined by the formula, I considered the company a “buy.” If the price was above 110% of the value, I considered the company a “sell.” Next, I created a mock portfolio of $100,000.00 and set about following the recommendations of the formula. When a rating changed to “buy,” I “bought” and when it changed to “sell,” I “sold.” I set a target weighting of 5% per company and left the remainder in cold hard cash when I did not achieve a full level of investment. Some very interesting things happened.
First, the portfolio held strong at a level of between 70 and 90% invested until Q4, 1998. At that point, the cash level increased to 46% and stayed between 40 and 60% until the end of 2003. After that, the cash level slowly decreased until 2006 when the portfolio reached a full investment level. As a result, the portfolio missed out on the over inflated market of the very late 90s and the subsequent recession and drop in value. Then once the price dropped relative to the value again, the portfolio increased the investment levels to take advantage of the low prices.
Second, the portfolio as a whole outperformed the index it was up against, the DJIA. On an annual basis, the Dow averaged an 11.5% gain over the period, compared to the portfolio’s 12.9%. In addition, the standard deviation of the Dow was 17.1% compared to 11.1%. So the portfolio achieved a higher rate of return with a lower level of risk.
The overall result was that if you had invested $100,000 in the Dow and $100,000 in the portfolio I tested, you would have $323,000 through the Dow and $408,000 through the portfolio today. I’d say that’s a significant difference, and here at ModernGraham we will be commencing use of the “modernized” formula that Graham provided in The Intelligent Investor for the foreseeable future.