Two Important Caveats

Two Important Caveats

The four valuation rules imply that a security’s firm-foundation value (and its price-earnings multiple) will be higher the larger the company’s growth rate and the longer its duration; the larger the dividend payout for the firm; the less risky the company’s stock; and the lower the general level of interest rates.

As indicated earlier, economists have taken rules such as these and expressed in a mathematical formula the exact price (present value) at which shares should sell. In principle, such theories are very useful in suggesting a rational basis for stock prices and in giving investors some standard of value. Of course, the rules must be compared with the facts to see if they conform at all to reality, and I will get to that in a moment. But before we even think of using and testing these rules in a very precise way, there are two important caveats to bear in mind.

Caveat 1: Expectations about the future cannot be proven in the present.

Remember, not even Jean Dixon can accurately predict all of the future. Yet some people have absolute faith in security analysts’ estimates of the long-term growth prospects of a company and the duration of that growth.

Predicting future earnings and dividends is a most hazardous occupation. It requires not only the knowledge and skill of an economist, but also the acumen of a psychologist. On top of that, it is extremely difficult to be objective; wild optimism and extreme pessimism constantly battle for top place.During the early 1960s, when the economy and the world situation were relatively stable, investors and no trouble convincing themselves that the coming decade would be soaring and prosperous. As a result, very high growth rates were projected for a large number of corporations. Years later, in 1980, the economy was suffering from severe “stagflation” and an unstable international situation. The best that investors could do that year was to project modest growth rates for most corporations.

The decline of literature indicates the decline of a nation (Johann Wolfgang von Goethe)

The point to remember is that no matter what formula you use for predicting the future, it always rests in part on the indeterminate premise. Although many Wall Streeters claim to see into the future, they are just as fallible as the rest of us. As Samuel Goldwyn once said, “Forecasts are difficult to make – particularly those about the future.”

Caveat 2: Precise figures cannot be calculated from undetermined data. It stands to reason that you can’t obtain precise figures by using indefinite factors. Yet to achieve desired ends, investors and security analysts do this all the time. Here’s how it’s done.

Take a company that you’ve heard lots of good things about. You study the company’s prospects, and suppose you conclude that it can maintain a high growth rate for a long period. How long? Well, why not ten years?

You then calculate what the stock should be “worth” on the basis of the current dividend payout, the expected future growth rate of dividends, and the general level of interest rates, perhaps making an allowance for the riskiness of the shares (if you actually want to do the calculation, just write out your estimates for the future flow of dividends expected, get hold of a vest-pocket calculator, and perform the whole operation while riding into work on the train). It turns out to your chagrin that the price the stock is worth is just slightly less than its present market price.

You now have two alternatives. You could regard the stock as overpriced and refuse to buy it, or you could say, “Perhaps this stock could maintain a high growth rate for eleven years rather than ten. After all, the ten was only a guess in the first place, so why not eleven years?” And so you go back to your calculator and lo and behold you now come up with a worth for the shares that is larger than the current market price. Armed with this “precise” knowledge, you make your sound purchase.

The reason the game worked is that the longer one projects growth, the greater is the stream of future dividends. Thus, the present value of a share is at the discretion of the calculator. If eleven years was not enough to do the trick, twelve or thirteen might well have sufficed. There is always some combination of growth rate and growth period that will produce any specific price. In this sense it is intrinsically impossible, given human nature, to calculate the intrinsic value of a share.

J. Peter Williamson, author of an excellent textbook for financial analysts entitled Investments, provides another example. In the book, Williamson estimated the present (or firm-foundation) value of IBM shares by using the same general principle of valuation I have described above; that is, by estimating how fast IBM’s dividends would grow and for how long. Williamson first made the sensible assumption that IBM would grow at a fairly high rate for some number of years before falling into a much smaller mature growth rate. In 1968, when he made his estimate, IBM was selling at $320 per share.

“I began by forecasting growth in earnings per share at 16%. This was a little under the average for the previous ten years… I forecast at 16% growth rate for 10 years, followed by indefinite growth at 2%. When I put all these numbers into the formula I got an intrinsic value of $172.94, about half of the current market value.”

Since the intrinsic value of IBM stock were so far apart, Williamson decided that perhaps his estimates of the future might not be accurate. He experimented further:

“It doesn’t really seem sensible to predict only 10 years of above average growth for IBM, so I extended my 16% growth forecast to 20 years. Now the intrinsic value came to $432.66, well above the market.”

Had Williamson opted for thirty years of above-average growth, he would be projecting IBM to generate a future sales volume about one-half the then current U.S. National income. With all due respect to IBM, such a growth rate did not seem possible. In fact, during the last five years of the 1980s IBM did not enjoy any earnings growth at all.

The point to remember from such examples is that the mathematical precision of the firm-foundation value formulas is based on treacherous ground: forecasting the future. The major fundamentals for these calculations are never known with certainty: they are only relatively crude estimates – perhaps one should say guesses – about what might happen in the future. And depending on what guesses you make, you can convince yourself to pay any price you want to for a stock.

There is a fundamental indeterminateness about the value of common shares even in principle. God Almighty does not know the proper price-earnings multiple for a common stock.

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.