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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.
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