IN the writer’s opinion, the factors determining the investment value of a common stock, given in the order of their importance, are: (1) earning capacity, (2) investment yield; (3) the nature of the industry; (4) the equity value; (5) the capital structure.
In a brief comment upon these factors, earning capacity and investment yield need no explanation. The nature of the industry needs only the explanation that the more hazardous and unstable the industry, the higher should be the investment yield ultimately demanded by the investor.
The term ‘equity value’ is used to mean an adjusted book value, under which balance-sheet values are adjusted to conform closer to real values, by the elimination of such items as goodwill, which will be given full consideration under earning capacity, the writing down of plant values where manifestly too high and up where manifestly too low, and the elimination of any questionable values.
The capital structure is very important, though generally not well understood. The strongest capital structure would be represented by a company with either nothing but common stock outstanding, or such a small amount of bonds and/or preferred stock that no serious consideration need be given them. However, pyramided capital structures frequently exist, whereby, through the issuance of large amounts of bonds and/or preferred stocks, the earnings upon a relatively small amount of common stock are greatly magnified. Obviously this large earning capacity cannot be given the same consideration as if it were obtained through a sounder capital structure, since it is subject to wide fluctuations both ways.
All of these factors enter into the problem of what constitutes a fair investment value for a common stock, and mention of them is made solely to illustrate the complexity of the problem and to emphasize the fact that any attempt to value common stocks upon only earnings per share, as is usually done, is manifestly superficial.
A brief illustration will suffice: Suppose two common stocks. A and B, each earn $15 per share annually. Judged solely by their earning capacity. A and B should have the same per share value. However. A may occupy a working-capital position of tremendous strength, with large investments in government bonds representing an excess of working capital materially above requirements; while B may occupy but a fair working-capital position and consequently should conserve its cash assets. It should require no argument to show that A may properly pay a dividend of $12 annually or even more, while sound financial policy would dictate a dividend of $9 or even less for B. Other things being equal, it is evident that the investment value of A materially exceeds such value for B.
We have heard much of late about this method of valuing stocks upon the superficial basis of considering earnings only, and the advocates of this method express their ideas in concrete form by placing the value of a common stock at ’so many times the annual earnings’ upon such stock, some using the index of fifteen times and others as high as twenty and twenty-five times.
While unquestionably this single factor is very important, and is so recognized by the writer in according it first place among the five factors enumerated above, those who place the value at ’so many times the annual earnings’ should appreciate the full significance of such an index.
The following table is presented to show the significance of this index, and in order to further that end it is arbitrarily assumed that a company may distribute in dividends 70 per cent of its net earnings applicable to the common stock.
| Ratio of Marled Value to Annual Per Share Earnings | Per Cent Earned on Market Price | Per Cent Investment Yield if 70 Per Cent of Earnings Are Paid in Dividends | ||
|---|---|---|---|---|
| (a) | 10 | times | 10.00 | 7.00 |
| (b) | 12 1/2 | “ | 8.00 | 5.60 |
| (c) | 15 | “ | 6.67 | 4.67 |
| (d | 20 | “ | 5.00 | 3.50 |
| (e) | 25 | “ | 4.00 | 2.80 |
To appreciate the full weight and significance of this tabulation, one should realize that if a common stock is selling at twenty times its annual per share earnings the investment would yield only 5 per cent if every dollar of earnings were paid out in dividends; only 4½ per cent if 90 per cent of earnings were so distributed, and only 3½ per cent if 70 per cent were so disbursed. (Amplification of d above.)
In order to determine what is a proper ‘investment value’ for a common stock, it is first necessary to refer to the investment yields afforded by bonds and preferred stocks of excellent quality, in order to judge what is the going investment interest rate for funds invested in securities devoid of any increased income element and reasonably safe from any decrease of income.
At this writing bonds and preferred stocks of excellent quality afford an investment yield of about 4.75 per cent, with a few variations both ways from that figure.
As common stocks by their very nature are subject to both increase and diminution of the dividend rate, it should he apparent that a common stock with a high degree of expectancy for the maintenance of its present dividend, but with an equally good assurance of no increase in the dividend rate within a reasonable time, should yield materially more than the 4.75 per cent obtainable from bonds and preferred stocks of excellent quality.
While opinions would necessarily vary as to how much more such a common stock should yield, perhaps an estimate of 5½ per cent might he fair to presume, to serve the writer’s purpose.
The question now arises as to what investment yield a common stock with the expectation of an increase in the dividend rate should afford, measured in terms of its present value.
Inasmuch as the increased dividend and the extent thereof arc elements of uncertainty, such common stock should yield more than the above 5½. per cent after the increase in the dividend rate has taken place, measured in terms of ‘present’ market value. Here we might suggest a 0 per cent ultimate yield as a fair basis of calculation.
Perhaps a simple illustration will serve to clear the point. A common stock which is earning $8 per share and paying $4 per share in dividends, when all factors are considered, possesses, let us assume, an expectancy of an increase in the dividend to $6 per share. Upon the basis suggested above, that the investor is entitled to a 6 per cent yield after the increase in the dividend becomes effective, this hypothetical common stock may be valued at 100. For the time being the investor purchasing at 100 receives only a 4 per cent yield, which is manifestly too low, but when the dividend shall have been increased to $6 per share his investment will then yield the required 6 per cent upon his original cost. When the uncertainties are considered, this would seem a fair basis.
Referring to the above illustration, it should be noted that the value of $100 per share is equivalent to 12½ times the earnings of $8 per share, and it is the writer’s personal opinion that such a ratio is about correct, and that, if error exists, a lower figure than 12½ times would be more fitting.
During the past fifteen years, at such times as common stocks were low, their prices have frequently reached the low figure of about five times their annual earnings; when prices were high, they attained about fourteen times annual per share earnings, and under normal market conditions about ten times. And so a ratio of about ten times was quite generally accepted by many authorities as a proper index.
However, in view of the declining investment interest rate, it would seem that this index may properly be adjusted to perhaps 12½ times under normal conditions, fluctuating both ways during periods of inflation and deflation marketwise.
To summarize, then: when common stocks sell at fifteen to twenty times their annual earnings (and many to-day are commanding from twenty-two to twenty-five times), one should weigh with extreme caution the probabilities of the outcome, as such high ratios can be warranted only upon the assumption that earning capacities will so increase in geometric progression as to justify such price levels.