Graham's Growth Stock Formula

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Posted by Bob on November 07, 1999 at 17:45:11:

The source of this formula of stock PRICE (as opposed to stock value) is not cited. Thus, the formula cannot be verified, and the ambiguity in the notation is unresolvable. The form of the model is P = E*(P/E).

Assume for the sake of argument that the model is PRICE = EPS*PE, where EPS is Earnings Per Share, and PE is Price-to-Earnings Ratio; or equivalently, PRICE = EPS*{[(2*EGR)+0.085]*(0.044/Yield)}, where EGR is Earnings Growth Rate (projected?), and Yield is the yield to maturity for a AAA-rated bond (of comparable term or duration?).

If this is the model, then (1) for a company with projected zero EPS growth, or flat EPS, or a constant EPS in perpetuity, and (2) with a current appropriate-term Yield equal to 4.40%, the Price-to-Earnings Ratio would be equal to 8.5 for the common stock. For a company with a projected EPS of $1.00 per share, the PRICE of its common stock would be equal to $8.50 per share.

Where did the 8.5% come from? Maybe the equation Y=(a*X+b)*Term is used to estimate the model PRICE = [(2*EGR)+8.5)]*Term, where the slope coefficient "a" is equal to 2, the Y-axis intercept "b" is equal to 8.5, and the constant Term is equal to [EPS*(4.4/Yield)]. Thus, the 8.5% would be the result of Ordinary Least Squares fitting of a sample of data to a straight line. Technically, the slope is equal to (2*Term), and the intercept is equal to (8.5*Term), but the Term can be extracted to clarify the model for discussion.

More likely, the model may be just another simplified ad hoc guesstimate based on the opinion that a zero-growth stock deserves a PE ratio of 8.5% if the appropriate-term AAA-rated bond yield is 4.40%. With this kind of model, all common stocks are PRICED in a linear extrapolation from this base point.

This is an example of a rule-of-thumb guideline or heuristic formula for pricing stocks. In each edition of their book entitled "Security Analysis," Graham and Dodd changed their formulas to reflect stock market conditions at the time of publication. As so-called growth stocks became more popular with each new edition of the book, their formulas gave increasing weight to a "growth" factor. What Graham wrote depends on both the book and on the edition in which he wrote it because he was speaking in terms of changeable empirical price data and not in terms of invariant basic valuation principles. This is an example of using 20/20 hindsight, continuously revised as more recent historical market-generated price data become available.

But then PRICE is not VALUE.

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