One More Caveat

One More Caveat

So market prices do seem to have an inherent logic. In each of many recent years, stock prices have been closely related to differential patterns of expected growth as well as to the other “fundamental” valuation influence so important to proponents of te firm-foundation theory. It looks like there may be a firm foundation of value after all, and some jokers in Wall Street actually think you can make money knowing what it is.

Caveat 3: What’s growth for the goose is not always growth for the gander. The difficulty comes with the value the market puts on specific fundamentals. It is always true that the market values growth, and that higher growth rates and larger multiples go hand in hand. But the crucial question is: How much more should you pay for higher growth?

There is no consistent answer. In some periods, as in the early 1960s and 1970s, when growth was thought to be especially desirable, the market has been willing to pay an enormous price for stocks exhibiting high growth stocks commanded only a modest premium over the multiples of common stocks in general.

The point is illustrated in the following table. IBM, during its rapid growth phase, consistently sold at a much higher multiple than the market. But the differential in multiples has been quite volatile. IBM’s multiple was over three times that of the market in December 1961. Five months later it was not even two times as great. At the low points in the market in 1970 and especially in 1980, IBM sold at only very small premiums over the general market. While it is true that the growth prospects for IBM were significantly lower in the 1980s than they were in the 1960s, the big changes in relative valuations between 1961 and 1962 and between 1968 and 1970 cannot be explained by changing expectations of IBM’s growth prospects.

One more caveat. Photo by Elena

Price-Earnings Multiples for IBM and for the Market in General

Market peak 1961 : P/E Multiples – IBM 64 S&P Index – 20. Premium IBM P/E as a % of S&P P/E 320%

Market peak 1962 : P/E Multiples – IBM 29 S&P Index – 16. Premium IBM P/E as a % of S&P P/E – 181%.

Market peak 1968 : P/E Multiples – IBM 50 S&P Index – 18. Premium IBM P/E as a % of S&P P/E – 278%.

Market peak 1970 : P/E Multiples – IBM 25 S&P Index – 16. Premium IBM P/E as a % of S&P P/E 156%.

Market peak 1972 : P/E Multiples – IBM 44 S&P Index – 17. Premium IBM P/E as a % of S&P P/E – 259%.

Market peak 1980 : P/E Multiples – IBM 9 S&P Index – 7. Premium IBM P/E as a % of S&P P/E – 129%.

(As measured by Standard & Poor’s Industrial Index 425-Stock Index through 1972, 400-Stock Index for 1980 figures).

A similar way of looking at the changing premiums paid for growth stocks since 1959 is shown in the following chart, which graphs the premiums for the Babson 28 Growth Stocks compared with the stocks of Standard & Poor’s 500-Stock Index. The chart tells a disappointing story for anyone looking for a consistent long-term valuation relationship. Growth can be as fully learned in the 1970s. During the Nifty Fifty craze, growth stocks reached their highest valuations relative to the market as a whole. During the 1980s, the premium for growth was lower than at any time during the preceding twenty years.

From a practical standpoint, the rapid changes in market valuations that have occurred suggest that it would be very dangerous to use any one year’s valuation relationships as one indication of market norms. However by comparing how growth stocks are currently valued with historical precedent investors should at least be able to isolate those periods when a touch of the tulip bug has smitten investors. When the first edition of this book was published in 1973, experts warned that growth stocks were extremely richly priced and that investors should approach these stocks with extraordinary care. This chart shows that the earnings multiples of growth stocks are now relatively modest and thus growth companies appear to offer attractive value for the years to come, relative to market as a whole (it may be argued correctly that the expected growth rates for the Babson 28 Growth Stock Index are probably lower at the start of the 19902, than they were at the start of the 1960s. The good relative values in growth stocks can be confirmed, however be observing the very modest price-earnings multiples for younger, emerging growth companies.

Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.