Testing the Rules

Testing the Rules

With the rules and caveats in mind, let us take a closer look at stock prices and examine whether the rules seem to conform to actual practices. Let’s start with Rule 1 – the larger the anticipated growth rate, the higher the price of a share.

To begin, we’ll reformulate the question in terms of price-earnings (P/E) multiples rather than the market prices themselves. This provides a good yardstick for comparing stocks – which have different prices and earnings – against one another. A stock selling at $100 per share with earnings of $10 per share would have the same P/E multiple (10) as a stock selling at $40 with earnings of $4 per share. It is the P/E multiple, not the dollar price, that really tells you how a stock is valued in the market.

Our reformulated question now reads: Are actual price-earnings multiples higher for stocks where a high growth rate is anticipated? A major study by John Cragg and Burton G. Malkiel strongly indicates that the answer is yes.

It was easy to collect the first half of the data required. P/E multiples are printed daily in papers such as the New York Times and the Wall Street Journal. To obtain information on expected long-term growth rates, the experts surveyed eighteen leading investment firms whose business it is to produce the forecasts upon which buy and sell recommendations are made. Estimates were obtained from each firm of the five-year growth rates anticipated for a large sample of stocks.

We will not bore you with the details of the actual statistical study that was performed. It is clear that just as Rule 1 asserts, high P/E rations are associated with high expected growth rates. This general pattern has held up in every year since 1961, when John Cragg and Burton G. Malkiel began the study.

Testing the Rules. Photo by Elena

In addition to demonstrating how the market values different growth rates, the chart can also be used as a practical investment guide. Suppose you were considering the purchase of a stock with an anticipated 15 percent growth rate and you knew that, on average, stocks with 15 percent growth sold, like Automatic Data Processing, at 18 times earnings. If the stock you were considering sold at a price-earnings multiple of 25, you might reject the idea of buying the stock in favor of one more reasonably priced in terms of current market norms. If, on the other hand, your stock sold at a multiple below the average in the market for that growth rate, the security is said to represent good value for you money. We’ll return to the practical use of such techniques, as well as the pitfalls, at several later points.

How about Rules 2,3, and 4? Just as we were able to test for a relationship between earnings multiple and anticipated growth rates, it was also possible to collect the necessary data and find the ways in which not only growth, but dividend payout, risk and interest rates influence price-earnings multiples in the market. The particular techniques used need not concern us. What is important to realize is that there does seem to be a logic to market valuations. Market prices seem to behave just as the four rules developed by the firm-foundation theorists would lead us to expect. It s comforting to know that at least to this extent there is an underlying rationality to the stock market.

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.