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April, 2016


According to Ben Graham, the average stock sells at a price to earnings ratio of 8.5, even if the company has no growth. Given that he and his partner, David Dodd, authors of Security Analysis, a classic work on value investing, considered the stocks of companies with real annual growth to be worth more than average, he came up with a formula to indicate an appropriate P/E for diverse growth rates: An apt price to earnings ratio in his view equaled 8.5 plus twice the growth rate (P/E = 8.5 + 2G). This idea has subsequently been revised to take into account changes in Federal Reserve rates and consequently in bond yields, i.e. a company's intrinsic value (V) equals earnings per share times (8.5 + 2G) times 4.4, all divided by the current 20-year AAA corporate bond yield, or, in other words: (the correct) P/E = (8.5 + 2G) x (4.4%/AAA). By implication, the formulas shows that, regardless of which is used, the classic or revised version, Graham envisioned relatively high P/E ratios as appropriate for sustained growth rates. A growth rate of 20% could have a P/E by these measures of at least 48.5. Even stocks with more modest 10% growth rates would not be regarded as overvalued if they had P/E ratios of no more than 28.5, while a mere 6% annual growth asset would not be considered too highly priced, in the new formula, if its P/E were 22. The catch is that we do not know what growth rates companies will have in future, and often we are merely guessing. Maybe it is better to compare the P/E ratios with historical growth rates, which certainly are known.

There are almost always companies available whose price to earnings ratios are significantly below the value investing suggested levels, given their historical growth. Some are considered too hazardous, small, untried by many years of operation, are suffering from worries about their particular industries, perhaps have managements that are temporarily under a cloud of some kind, etc. If the company being researched can indeed sustain anything like its past growth levels, then these much lower P/E ratios are not justified, and sooner or later its stock will surge toward more appropriate pricing.

There is never a lack of some risk, though, so Graham suggested we add margins of safety into our investing. If a company's past growth rate seems overall likely to continue or even to increase for awhile, thus supporting a reasonably higher P/E per the Graham type calculations, yet its stock is actually selling at a much lower P/E, this difference is the kind of margin of safety Ben Graham would have coveted. Even for a portfolio of riskier stocks, so much margin of safety as to acquire the assets at 2/3 or less of their appropriate price to earnings levels in relation to historical growth seems reasonable.

Growth at a Bargain
Price to
Atwood Oceanics, Inc.ATW$8.671.3912.74%
Cal-Maine Foods, Inc.CALM$52.256.9366.10%
PDL BioPharma, Inc.PDLI$3.601.7912.07%
Sketchers USA, Inc.SKX$29.3619.13183.36%
Skyworks Solutions, Inc.SWKS$74.7415.2953.88%
Tech Data Corp.TECD$71.639.7515.57%
Tesoro Corp.TSO$82.816.5439.54%
Valero Energy Corp.VLO$60.717.4529.57%
(Average P/E: 8.53)
(Average 3-year earnings growth: 51.60%)

At the table is a selection of stocks selling well below their reasonable P/Es in view of trailing three-year growth rates. Each has a current P/E no greater than two-thirds the historical rate of annual earnings growth. This is only the beginning of the selection process. One still needs to consider a variety of factors in deciding which assets to add to a portfolio. Nonetheless, all of these equities appear to me to be promising at current P/E levels in relation to past earnings growth.

An approach might be to gradually purchase 20-30 such stocks, and thereafter to sell the then weakest in terms of risk-adjusted prospects (for instance if by then the P/E to growth rate differential were but modest), replacing each one sold, for example once a month, with a new asset that now better meets the original criteria.

Good luck with your own investing research and results.


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

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