Benjamin Graham

Chapter 13 – A Comparison of Four Listed Companies

Summary and Discussion- Chapter 13 – A Comparison of Four Listed Companies
Notes on The Intelligent Investor by Benjamin Graham
Notes by Jason Fernando
Created March 3rd, 2014
Last updated May 17th, 2014
Reference document: Graham, Benjamin, and Jason Zweig. The Intelligent Investor. Rev. ed. New York: HarperBusiness Essentials, 2003.

50-Word Recap

  • Graham demonstrates a multi-step process for assessing the relative strength and valuation of four companies.
  • This process takes the profitability, stability, and price of the companies into consideration—along with other factors.
  • I demonstrate this process in relation to four modern technology companies: Google, Microsoft, Apple and Blackberry.

Chapter 13 is one of my favourite chapters of The Intelligent Investor. Here, Graham applies his investment principles to the analysis of four publicly listed companies, based on data from their SEC financial statements. [1] I will begin by summarizing the chapter in our usual manner. Afterwards, I will repeat the process using four new companies which are publically traded today. [2]

The four companies which Graham compares in this chapter are Eltra Corporation, Emerson Electric Company, Emery Air Freight, and Emhart Corporation. Graham’s detailed comparison of the companies is based on a collection of financial data compiled in Tables 13-1 and 13-2. I have reproduced these tables on the next two pages and have highlighted in bold the specific financial data which Graham refers to in his analysis. [3] However, I encourage readers to look beyond these figures to investigate the extent to which the broader set of data relates to the conclusions arrived at by Graham, as well as to appraise the respective strength and value of these companies from your own individual perspective. Finally, the “Explanation of Terms” column to the right of Graham’s analyses will feature definitions as they are used today. The names and meanings of some terms have changed since Graham’s day; the definitions provided may therefore differ somewhat from their intended meaning. Links to more detailed explanations will be included throughout.

Table 13-1: A Comparison of Four Listed Companies [4]

A. Capitalization ELTRA Emerson Electric Emery Air Freight Emhart Corp.
Price of common, Dec. 31, 1970 $27 $66 $57¾ 32¾
Number of shares of common 7,714,000 24,884,000 [5] 3,807,000 4,932,000
Market value of common $208,300,000 $1,640,000,000 $220,000,000 $160,000,000
Bonds and preferred stock $8,000,000 $42,000,000 $0 $9,200,000
Total capitalization $216,300,000 $1,682,000,000 $220,000,000 $169,200,000
B. Income Items
Sales, 1970 $454,000,000 $657,000,000 $108,000,000 $227,000,000
Net income, 1970 $20,773,000 $54,600,000 $5,679,000 $13,551,000
Earned per share, 1970 $2.70 $2.30 $1.49 $2.75 [6]
Earned per share, ave., 1968-1970 $2.78 $2.10 $1.28 $2.81
Earned per share, ave., 1963-1965 $1.54 $1.06 $0.54 $2.46
Earned per share, ave., 1958-1960 $0.54 $0.57 $0.17 $1.21
Current dividend $1.20 $1.16 $1.00 $1.20
C. Balance-sheet Items, 1970
Current assets $205,000,000 $307,000,000 $20,400,000 $121,000,000
Current liabilities $71,000,000 $72,000,000 $11,800,000 $34,800,000
Net assets for common stock $207,000,000 $257,000,000 $15,200,000 $133,000,000
Book value per share $27.05 $10.34 $3.96 $27.02

Table 13-2: A Comparison of Four Listed Companies (continued[7]

B. Ratios ELTRA Emerson Electric Emery Air Freight Emhart Corp.
Price/earnings, 1970 10.0 X 30.0 X 38.5 X 11.9 X
Price/earnings, 1968-1970 9.7 X 33.0 X 45.0 X 11.7 X
Price/book value 1.00 X 6.37 X 14.3 X 1.22 X
Net/sales, 1970 4.6 % 8.5 % 5.4 % 5.7 %
Net per share/book value 10.0 % 22.2 % 34.5 % 10.2 %
Dividend yield 4.45 % 1.78 % 1.76 % 3.65 %
Current assets to current liabilities 2.9 X 4.3 X 1.7 X 3.4 X
Working capital/debt [8] Very large 5.6 X No debt 3.4 X
Earnings growth per share:
1968-1970 vs. 1963-1965 + 81% + 87% + 135% +14 %
1968-1970 vs. 1958-1970 +400% +250% Very large +132%
C. Price Record
1936-1968 Low $ ¾ $ 1 $ ⅛ $ 3⅝
1936-1968 High $ 50¾ $ 61½ $ 66 $ 58¼
1970 Low $ 18⅝ $ 42⅛ $ 41 $ 23½
1971 High $ 29⅜ $ 78¾ $ 72 $ 44⅜

Step 1: Compare price/earnings ratios to operating performance and financial condition

Graham Says… Commentary
“The most striking fact about the four companies is that the current price/earnings ratios vary much more widely than their operating performance or financial condition. Two of the enterprises—ELTRA and Emhart—were modestly priced at only 9.7 times and 12 times the average earnings from 1968-1970, as against a similar figure of 15.5 times for the [Dow Jones Industrial Average, or “DJIA”]. The other two—Emerson and Emery—showed very high multiples of 33 and 45 times such earnings. There is bound to be some explanation of a difference such as this, and it is found in the superior growth of the favored companies’ profits in recent years, especially by the freight forwarded. (But the growth figures of the other two firms were not unsatisfactory.” [9] Price/earnings ratio: This ratio is calculated by dividing the company’s share price by its earnings per share. For example, ELTRA’s share price ($27) divided by its earnings per share ($2.70) gives a price/earnings ratio of 10 X. [10] More information.

Step 2: Compare profitability

Graham Says… Commentary
“(a) All the companies show satisfactory earnings on their book value, but the figures for Emerson and Emery are much higher than for the other two. A high rate of return on invested capital often goes along with a high annual growth rate in earnings per share. All the companies except Emery showed better earnings on book value in 1969 than in 1961; but the Emery figure was exceptionally large in both years. (b) For manufacturing companies, the profit figure per dollar of sales is usually an indication of comparative strength or weakness. We use here the “ratio of operating income to sales,” as given in Standard & Poor’s Listed Stock Reports. Here again the results are satisfactory for all four companies, with an especially impressive showing by Emerson. The changes between 1961 and 1969 vary considerably among the companies.” [11] Book value: A good summary of the various definitions which can apply to “Book value” is provided by Graham seems to have arrived at his Book value per share figures (Table 13-1) by dividing Net assets for common stock by Number of shares of common. However, there are other ways of calculating book value per share.
Earnings per share: Graham gets his Earned per share figures (Table 13-1) by dividing Net income by Number of shares of common. There are other ways of calculating earnings per share, just as there are other ways of defining earnings per share.
Profit/sales: Today, we would refer to this figure simply as profit margin. Graham gets this figure (Net/sales in Table 13-1) by dividing Sales by Net income.

Step 3: Compare stability

Graham Says… Commentary
“…We measure [stability] by the maximum decline in per-share earnings in any one of the past ten years, as against the average of the three preceding years. No decline translates into 100% stability, and this was registered by the two popular concerns. But the shrinkages of ELTRA and Emhart were quite moderate in the “poor year” 1970, amounting to only 8% each by our measurement, against 7% for the DJIA.” [12] What Graham is saying here is that we can get a sense of the relative stability of these four companies by looking at the extent to which their earnings per share have fluctuated in the past. Specifically, he recommends comparing each company’s worst decline in any one of the past 10 years with the average decline of the three preceding years. The figures for earnings per share are housed under section B (“Income Items”) of Table 13-1.


Step 4: Compare growth

Graham Says Commentary
“The two low-multiplier companies show quite satisfactory growth rates, in both cases doing better than the Dow Jones group. The ELTRA figures are especially impressive when set against its low price/earnings ratio. The growth is of course more impressive for the high-multiplier pair.” [13] “The two low-multiplier companies” are ELTRA and Emhart. By “low-multiplier”, Graham is referring to their low price/earnings ratios. [14] Graham acknowledges that the two companies (Emerson and Emery) with higher price/earnings ratios display superior growth, while implying that the low price/earnings ratios of ELTRA and Emhart may indicate superior value overall.

Step 5: Financial Position

Graham Says Commentary
“The three manufacturing companies are in sound financial condition, having better than the standard ratio of $2 of current assets for $1 of current liabilities. Emery Air Freight has a lower ratio; but it falls in a different category, and with its fine record it would have no problem raising needed cash. All the companies have relatively low long-term debt.” [15] The “three manufacturing companies” are ELTRA, Emerson Electric, and Emhart Corp. The “standard ratio” is given as Current assets to current liabilities in Table 13-2. Graham arrives at these figures by dividing each firm’s current assets by its current liabilities. In a nutshell, the resulting ratio gives you an idea of the extent to which each company could pay off its current debts and expenses at any given time. For example, ELTRA’s current assets ($205,000,000), divided by its current liabilities ($71,000,000), equals 2.9. This means that could (in theory) pay off its current liabilities 2.9-times over at any given time.

Step 6: Compare dividends

Graham Says… Commentary
“What really counts is the history of continuance without interruption. The best record here is Emhart’s, which has not suspended a payment since 1902. ELTRA’s record is very good, Emerson’s quite satisfactory, Emery Freight is a newcomer. The variations in payout percentage do not seem especially significant. The current dividend yield is twice as high on the “cheap pair” as on the “dear pair,” corresponding to the price/earnings ratios.” [16] Graham has good reason to assert that uninterrupted dividend payments are “What really counts”. Here are just four reasons why: a) Uninterrupted dividends are indicative of stable management; [17] b) “ are necessary for compounding to occur; [18] c) “ defray the adverse effects of “bad” years; d) “ make mediocre years profitable. [19]

Step 7: Compare price history

Graham Says… Commentary
“The reader should be impressed by the percentage advance shown in the price of all four of these issues, as measured from the lowest to the highest points during the past 34 years. (In all cases the low price has been adjusted for subsequent stock splits.) Note that for the DJIA the range from low to high was on the order of 11 to 1; for our companies the spread has varied from “only” 17 to 1 for Emhart to no less than 528 to 1 for Emery Air Freight. These manifold price advances are characteristic of most of our older common-stock issues, and they proclaim the great opportunities of profit that have existed in the stock markets of the past. (But they may indicate also how overdone were the declines in the bear markets before 1950 when the low prices were registered.) Both ELTRA and Emhart sustained price shrinkages of more than 50% in the 1969-70 price break. Emerson and Emery had serious, but less distressing, declines; the former rebounded to a new all-time high before the end of 1970, the latter in early 1971.” [20] Graham is referring to the first two rows under section C (“Price Record”) of Table 13-2.
Stock splitsare a type of corporate action in which a company’s number of shares outstanding is multiplied by a certain amount, while the price of each share is divided by that same amount. For example, in a 2 for 1 stock split, a company would double its number of shares outstanding while cutting the price of each share in half. It is important to adjust for stock splits when analyzing companies’ price histories in order to get an accurate picture of how the market capitalization of the companies have changed over time.
By “the spread”, Graham is here referring to the difference between the highest and the lowest share prices recorded by each of the four companies between 1936 and 1968. For example, Emery Air Freight’s “spread” is 528 to 1 because its highest share price during this period was 528 times its lowest share price (66 divided by 0.125 = 528).

General Observations on the Four Companies

Graham uses this section to take a holistic view of each of these four companies, reflecting on aspects of their businesses and industries which do not fit neatly into any of the preceding stages of analysis. I won’t reprint this section in full because it is by its nature specific to the four particular companies at issue. However, a summary of the kinds of observations which Graham raises is as follows: [21]

  1. Comparison of total market value, a.k.a. “market capitalization”.
  2. Assessment of relative “good will” enjoyed by each company, leading to the question: is this good will justified?
  3. Consideration of future growth which is implied by current price/earnings ratios. If a company (such as Emery Air Freight) trades at a high price/earnings ratio, the implication is that its shareholders expect an equally high rate of future growth (so much so that they are willing to pay handsomely for that future growth ahead of time). The investor should thus ask herself: are such growth expectations justified? And even if they are, is the price which one would pay for this expected growth justified?
  4. Consideration of the relative current “sex appeal” (or lack thereof) of the companies. How are they perceived by investors? Are their financial reports eagerly followed by a large “cult” of investors, or are they relatively ignored by the market? How much this fame/obscurity affect the company’s price performance in the future? Too much fame can lead to volatile and erratic price movements, while too much obscurity can lead to good companies performing below their value for indefinite periods of time.
  5. Last (and, in my personal opinion, very much least), what do the Wall Street analysts think? [22]

Graham concludes this chapter by summarizing the “seven statistical [as opposed to qualitative] requirements for inclusion in a defensive investor’s portfolio. These will be developed in the next chapter, but we summarize them as follows:

1. Adequate size.

2. A sufficiently strong financial condition.

3. Continued dividends for at least the last 20 years.

4. No earnings deficit in the past ten years.

5. Ten-year growth of at least one-third in per-share earnings.

6. Price of stock no more than 1½ times net asset value.

7. Price no more than 15 times average earnings of the past three years.” [23]

Graham skillfully ends this chapter on a tantalizing note. But, before moving on to Chapter 14, I want to reiterate the above process of analysis—this time applying it to four companies which made their public debuts well after Graham’s time. To this end, I will apply the eight stages of Graham’s analysis (eight, if you count the general reflections at the end) to four companies which are likely to be much more familiar than the four chosen by Graham: [24] Google, Microsoft, Apple, and Blackberry.

Table 13-1: A Comparison of Four Listed Companies

A. Capitalization Google Microsoft Apple Blackberry
Price of common, March 2014 $1,207.30 $37.89 $523.30 $9.27
Number of shares of common [25] 336,050,831 [26] 8,329,956,402 939,208,000 524,159,844
Market value of common $405,714,168,266 $315,622,048,071 $491,487,546,400 $4,858,961,754
Bonds and preferred stock [27] $4,000,000,000 $22,800,000,000 $17,000,000,000 $0
Total capitalization $409,714,168,266 $337,310,000,000 $508,487,546,400 $4,858,961,754
B. Income Items
Sales, 2013 [28] $59,825,000,000 $77,849,000,000 $170,910,000,000 $11,073,000,000
Net income, 2013 $12,920,000,000 $21,863,000,000 $37,037,000,000 ($646,000,000) [29]
Earned per share, 2013 [30] $36.05 $2.58 $39.75 [31] ($1.20)
Earned per share, ave., 2011-2013 $32.76 $2.42 $37.19 $2.44
Earned per share, ave., 2006-2008 $12.18 $1.50 $3.85 $1.33
Earned per share, ave., 2001-2003 $0.77 $0.76 [32] $0.1 [33] ($0.78)
Current dividend $0.00 $0.28 $3.05 $0.00
C. Balance-sheet Items, 2013
Current assets $72,886,000,000 $101,466,000,000 $73,286,000,000 $7,101,000,000
Current liabilities $15,908,000,000 $37,417,000,000 $43,658,000,000 $3,448,000,000
Net assets for common stock [34] $87,309,000,000 $78,944,000,000 $123,549,000,000 $9,460,000,000
Book value per share [35] $259.81 $9.48 $131.55 $18.05

Table 13-2: A Comparison of Four Listed Companies (continued)

B. Ratios Google [36] Microsoft Apple Blackberry
Price/earnings, 2013 33.49 X 14.69 X 13.16 X N/A [37]
Price/earnings, 2011-2013 36.85 X 15.66 X 14.07 X 3.80 X
Price/book value 4.65 X 4.00 X 3.98 X 0.51 X
Net/sales, 2013 21.60% 28.08% 21.67% N/A [38]
Net per share/book value 13.88% 27.22% 30.22% N/A [39]
Dividend yield 0.00% 2.90% 2.32% 0.00%
Current assets to current liabilities 4.58 X 2.71 X 1.68 X 2.06 X
Working capital/debt 14.24 X 2.81 X 1.74 X N/A [40]
Earnings growth per share:
2011-2013 vs. 2006-2008 168.97% 61.33% 865.97% 83.46%
2011-2013 vs. 2001-2013 4155.55% 218.40% 37,090.00% N/A [41]
C. Price Record
1979-2011 Low $100.01 [42] $0.093 [43] $11.50 [44] $1.53 [45]
1979-2011 High $714.87 [46] $58.72 [47] $422.00 [48] $230.52 [49]
2013 Low $704.51 [50] $26.74 [51] $390.53 [52] $5.88 [53]
2014 High $1220.17 [54] $39.55 [55] $594.09 [56] $10.78 [57]

Step 1: Compare price/earnings ratios to operating performance and financial condition

As in Graham’s analysis, these companies are remarkable for their divergent price/earnings ratios. Google’s PE ratio of 33X is 120% greater than that of Microsoft (15X). This increased price is partially offset by Google’s superior EPS growth in recent years (10.04% increase for Google vs. a 6.61% increase for Microsoft—a difference of 52%). However, viewed in and of themselves, Google’s net income and profit margin do not seem sufficiently superior to justify its elevated PE ratio. Indeed, viewed side by side, the markedly divergent PE ratios of Google and Apple are particularly notable, especially considering a) the nearly identical profit margins of the two firms, and b) Apple’s vastly superior net income.

Profit vs Price and Profit Margin

Step 2: Compare profitability

How do Google, Microsoft, Apple, and Blackberry compare with regard to their profitability? Three out of the four companies show strong earnings as a percentage of book value, with Apple the leader at 30.22%, followed by Microsoft (27.22%) and finally Google (13.88%). [58]

Net EPS as a Percentage of Book Value

These figures provide a kind of snapshot of the companies’ most recent annual performance c. March 2014. To gain a greater understanding of their relative profitability over time, we can consult their annual growth rate in earnings per share. In doing so, it becomes apparent that Apple’s EPS growth in recent years has been explosive even relative to its fast-growing rivals. Comparing the period of 2006-2008 with that of 2011-2013, Apple’s EPS growth has increased by 865.97%—more than five times the growth rate of Microsoft, its nearest competitor.

Earnings Growth per Share - 2011-2013 vs 2006-2008

The situation changes, however, when we limit our scope to more recent EPS figures. Comparing 2013 EPS to the average EPS from 2011 to 2013, Google pulls to the head of the pack with an EPS growth rate of 10.04%. Apple and Microsoft follow closely behind with growth rates of 6.88% and 6.61%, respectively. [59] With the exception of Blackberry, each company has shown significant EPS growth in recent years.

Step 3: Compare stability

We can begin by recalling Graham’s working definition of “stability”:

“…We measure [stability] by the maximum decline in per-share earnings in any one of the past ten years, as against the average of the three preceding years. No decline translates into 100% stability…” [60]

Google, Microsoft, and Apple have each experienced no decline in per-share earnings whatsoever. Consequently, they can be said to have “100% stability” according to the definition used by Graham.

EPS Growth - 2013 vs 2011-2013

Here again, Blackberry is the exception; its 2013 EPS of -$1.20 represents a decline of 149.2% relative to its 2011-2013 average of $2.44 per share. The instability of Blackberry’s earnings is amply illustrated when we compare its most recent earnings with select three-year periods since 2001.

Blackberry Earnings Instability

Step 4: Compare growth

As we have seen in step 1, the long-term growth for all four companies has been quite strong, with Apple’s growth in a league of its own. Yet how does this growth compare to the prices being paid by investors? We can begin to answer this question by viewing the companies’ 2013 PE ratios alongside their 2011-2013 EPS growth.

2011-2013 EPS Growth vs 2013 PE

As we might expect given its high PE ratio of 33.49X earnings, Google’s EPS growth in recent years has been impressive. However, Microsoft and Apple’s growth has also been sound. Of particular note are both firms’ comparatively low PE ratios of 14.69 and 13.16X earnings, respectively.

Step 5: Financial position

Recalling Graham’s analysis from earlier in this article, we can begin to assess the financial condition of a company by determining whether it has “better than the standard ratio of $2 of current assets for $1 of current liability.” [61] Let’s see how Google, Microsoft, Apple, and Blackberry compare with regard to this ratio.

Current Assets Current Liabilities Ratio of Current Assets to Current Liabilities
Google $72,886,000,000 $15,908,000,000 4.58 X
Microsoft $101,466,000,000 $37,417,000,000 2.71 X
Apple $73,286,000,000 $43,658,000,000 1.68 X
Blackberry $7,101,000,000 $3,448,000,000 2.06 X

As we can see from this table, all our companies exceed the standard 2-to-1 ratio of current assets to current liabilities, with the exception of Apple. However, as Graham notes in his analysis, investors can reasonably make exceptions for firms which they feel would have no trouble raising money in the event that they need to cover their liabilities. At the time of writing, most would agree that Apple falls into this category.

Step 6: Compare dividends

This section is a bit more difficult than the others, because Graham did not include the data he uses in his tables. Therefore, I have reproduced my own table containing the dividend payment history of our four companies. The sources from which this data is derived are listed in the footnotes.

First Dividend Latest Dividend Missed Dividends
Google None None N/A
Microsoft [62] 2003 (Annual) 2014 (3rd Quarter) 0
Apple [63] 1987 (April 22nd) 2014 (April 23rd) 64 [64]
Blackberry None None N/A

In addition to evaluating the consistency of their dividend payments, investors would be wise to consider the dividend yields offered by each company. As a reminder, the “dividend yield” refers to the percentage of the price of the stock that is paid to shareholders in the form of a dividend. Because the dividend yield is calculated as a percentage of the price, it follows that a higher price corresponds to a lower dividend yield and vice-versa. In other words, there is an inverse relationship between the price of a given stock and its dividend yield. For example, Microsoft’s stock price (from Table 13-1) is $37.89 per share, while its dividend is $0.28. Because dividends are paid out on a quarterly basis (4 times per year), we must multiply the dividend by 4 in order to then determine its dividend “yield”: $0.28 per quarter  x 4 quarters = $1.12 per year. What this number tells you is that, for every share of Microsoft which you own, you will be paid $1.12 cash per year. To find the yield, we simply must divide the annual dividend ($1.12) by the share price ($37.89): $1.12 ÷ $37.89 = 0.0296 or2.96%. Repeating this process for Apple, we arrive at a dividend yield of 2.33%.

Dividend Yield vs Price-Earnings Ratio

In light of its perfect payment record, its relatively low PE ratio and its relatively high dividend yield, Microsoft emerges as the clear favourite from this stage of our analysis. [65]

Step 7: Compare price history

Graham compares the price history of his companies by comparing their lowest to highest prices over the last 34 years, taking care to adjust this figure for stock splits which have occurred during this period. Given that the companies we are surveying have existed for significantly less time than those surveyed by Graham, I have elected to find data for the full period in which each company has been publicly traded. Therefore, the data below is drawn from each firm’s IPO forward through to the present day. [66] When we make this comparison between our chosen companies, we arrive at the following table:

Lowest Price Highest Price Price Spread
Google [67] $100.01 [68] $1216.86 [69] 12.17 times
(1,217% increase)
Microsoft $0.093 [70] $58.72 [71] 631.4 times (63,140% increase)
Apple $11.50 [72] $700.10 [73] 60.88 times (6,088% increase)
Blackberry $1.53 [74] $230.52 [75] 150.67 times (15,067% increase)

General Observations

I. Comparison of total market value, or “market capitalization”.

Google, Microsoft and Apple are among the largest publically traded corporations in the world; Blackberry, by contrast, is comparatively small. We can see their relative sizes in the chart below. [76]

Relative Market Capitalization

As we can see, Blackberry’s market capitalization of 3.84 billion USD is a miniscule fraction of its tech-giant competitors. Indeed, by today’s market capitalization figures Blackberry could ‘fit’ inside Google, Microsoft, and Apple 91, 85, and 131 times over, respectively! This dramatic discrepancy in size is a relatively recent phenomenon. At Blackberry’s all-time high in July 2007 the company was valued by investors at $230.52 per share. Given that Blackberry had approximately 557.61 million shares outstanding in March 2007, its July 2007 market capitalization was roughly $128.54 billion USD. [77]

II. Assessment of relative “good will”

Goodwill is an intangible asset which is listed on a company’s balance sheet alongside other assets. Examples of what constitutes goodwill include the branding of a company, its intellectual property (such as its patents), and/or its reputation with clients and customers. This list is by no means exhaustive. For a more in-depth definition of goodwill, see Investopedia’s article and video on the subject.

There is nothing intrinsically wrong with a company listing goodwill on its balance sheet. In certain cases, intangible assets such as patents or a strong brand are clearly important components of a company’s operations (who would doubt, for instance, that Apple’s famous “white earphones” advertisement campaign did wonders for its iPod product line, and thus its bottom line?). Yet, in other instances, companies can inflate their reported assets by recording unreasonably high goodwill on their balance sheets. The chart below shows us where Google, Microsoft, Apple, and Blackberry stand in relation to the goodwill listed on their balance sheets. [78] For the sake of comparison, I have included goodwill figures in both absolute dollar terms and as a percentage of the company’s total assets.

Relative Goodwill

III. Consideration of future growth which is implied by current price/earnings ratios.

The question of how current price/earnings ratios relate to future growth is a notoriously difficult subject to tackle. The source of this difficulty lies in a) the wide variety of tools which have enabled investors to (ostensibly) predict the future growth of individual companies or of the stock market as a whole, and b) the dramatic failure of these tools to produce accurate predictions. I won’t get into a long discussion about the futility of predicting future stock market movements here, but suffice it to say that ample research has been done on this topic and their overwhelming consensus is that efforts to predict the stock market are essentially a waste of time. For those interested in pursuing this topic more deeply, there is an interesting Vanguard research document from October 2012 which provides a clear and engaging introduction to the relative effectiveness of various “signals” which are commonly used to forecast stock-market returns. [79]

For our purposes, it is sufficient to note that a higher current PE ratio implies higher expectations for future growth. If a company has a PE ratio of 10, its investors are paying the equivalent of 10 times the company’s current earnings per share for every share of the company that they own. If the company were guaranteed to not grow at all, then this would be a terrible investment; effectively, what it would mean is that the investor would need to wait 10 years just to recuperate their initial investment. Investors pay more than the company’s current earnings based on the expectation that that company will grow its earnings during the period of time that the investor owns the company’s shares, thereby reducing the amount of time required for the investor to recuperate her investment. In principle, it makes perfect sense for investors to pay a premium over a company’s current earnings to reflect that company’s growth potential. However, a common trap that investor fall into is paying too much today for expected profits tomorrow (in other words, paying too much for expected future growth). Consequently, when we are assessing whether the PE ratio of a given company is appropriate, we are essentially assessing the expected future growth of that company. While it is impossible to say with certainty whether a given company is over or underpriced relative to its earnings, a number of “rules of thumb” can be used to help investors get a general picture of whether the price they’re paying for a given stock is high or low. Let’s have a look at some of these rules of thumb and see how they work when applied to Google, Microsoft, Apple, and Blackberry.

→ PE Ratios relative to industry.

A good place to start is assessing how the company’s PE ratio compares to competitors in its industry. This information is readily available through websites such as MorningStar, Google Finance, or Yahoo Finance. If we divide the industry average PE ratios by the PE ratio of the specific company, we get a figure which we can then compare to the other companies. This might sound confusing when stated abstractly, but it is simple and intuitive when put into practice. Let’s experiment with this method with our four tech companies.

PE Ratio Industry Avg. PE Industry Average / Company PE
Google [80] 28.7 38.2 1.33
Microsoft [81] 14.9 16.6 1.11
Apple [82] 14.0 14.0 1.00
Blackberry [83] N/A 38.8 N/A

When we chart these values, we arrive at this convenient side-by-side comparison:

PE Ratios Relative to Industry

A chart like this can be useful to give investors a general sense of how their chosen companies’ price compares to their industry competitors. Looking at this chart, we might conclude that Google deserves especially close attention in order to determine whether investors may be overpaying for the company at current prices. However, a chart such as this does little more than alert investors to potential overvaluation; it does not offer a definitive verdict in either case. Moreover, an additional weakness of this chart is that it is not clear from MorningStar’s interface how exactly their data on industry average PEs is calculated.

Analysts’ expectations and the Price-Earnings/Growth Ratio (PEG)

A common tool used by investors to assess the valuation of their shares is the Price-Earnings/Growth (or “PEG”) Ratio.  This ratio relates the company’s PE ratio to its annual EPS growth rate and is calculated by dividing the PE ratio by the rate of annual EPS growth (PE / EPS Growth). Investors using the PEG ratio may choose between past or “trailing” EPS growth or “forward” EPS growth. Investors also may choose what duration of time they wish to include when calculating EPS growth (average annual growth over 5 years, 10 years, 15 years, etc.) If one chooses to use trailing EPS, then this figure can be calculated more or less objectively by taking the average rate of annual growth over the chosen period of time. If one chooses to use forward EPS, then one must rely on analysts’ expectations. Let’s explore this further by experimenting with each kind of PEG ratio.

i) Trailing PEG Ratio

The trailing PEG ratio is calculated as follows:

Trailing X-year PEG Ratio =PE Ratio Average Annual EPS Growth over Past X Years

Obviously, we need to decide how many years of EPS growth we wish to include in our ratio. For the sake of simplicity, let’s choose 5 years. We can rewrite our calculation as:

5 year PEG Ratio = PE Ratio 5 year Average EPS Growth

These days, it’s easy to find these figures automatically using online tools such as MorningStar, Google Finance, etc. But for the sake of clarity, let’s work through the process by hand.

We can begin by compiling a table of our companies’ average annual EPS figures for each of the past five years.

Table 1-A

2009 2010 2011 2012 2013
Google [84] $10.21 $13.17 $14.89 $16.17 $19.08
Microsoft [85] $1.62 $2.10 $2.69 $2.00 $2.58
Apple [86] $9.08 $15.15 $27.68 $44.15 $39.75
Blackberry [87] $3.30 $4.31 $6.34 $2.22 -$1.23

Next, we can determine the average annual growth for each of these years (the extent to which EPS grew, on average, from one year to the other). Then, we can take the average of these figures.

Table 1-B

2009 to 2010 2010 to 2011 2011 to 2012 2012 to 2013 5-year
Trailing Average Annual EPS
Google [88] 28.99% 13.06% 8.60% 18% 17.16%
Microsoft [89] 29.63% 28.1% -25.65% 29% 15.27%
Apple [90] 66.85% 82.71% 59.5% -9.97% 49.77%
Blackberry [91] 30.61% 47.1% -64.98% -155.4% -35.67%

Now that we have our average annual EPS figures (the 5-year averages), we can plug them into the PEG Ratio equation. I’ll use Google as an example.
5 year PEG Ratio (Google) = PE Ratio 17.16

For PE Ratio, we take the PE from the most recent full year. Google’s 2013 average PE was 23.5, so we can complete the equation as follows: [92]

5 year PEG Ratio (Google) = 23.5 17.16

5 year PEG Ratio (Google) = 1.37

As a rule of thumb, a PEG Ratio less than one indicates undervaluation, while a ratio greater than one indicates overvaluation (a ratio equal to one, appropriately, indicates fair valuation). In our case, Google’s PEG ratio of 1.37 suggests that the company is overvalued. More specifically, it suggests that the company’s average annual EPS growth over the past 5 years does not justify its average annual share price for the most recent fiscal year (2013). Of course, it would be perfectly reasonable to invest in Google provided that one had reason to believe that the company’s future growth (say, over the next 5 years) will increase at such a pace as to justify these prices. [93] One tool for thinking about a company’s future growth is the forward PEG ratio. To use this tool, we use the same formula as above while replacing our trailing EPS growth figure with analysts’ expected EPS growth. Ideally, we would use analysts’ expected EPS growth for the next five years in order to be consistent with the inputs we used for the trailing PEG ratio. However, analysts’ projections are usually limited to one year into the future, which is probably a good precaution given how difficult it is to make accurate predictions. Consequently, the EPS growth portion of our forward PEG equation will be limited to the analysts’ expected EPS growth from the current year (2014 at the time of writing) to the next. [94] We can therefore rewrite our equation as follows:

Forward PEG Ratio =PE Ratio Average Analyst Estimate for EPS Growth over 1 year

Because the Forward PEG Ratio concerns future growth, I’ll use Google’s most recent PE Ratio (29 times earnings) and EPS ($19.33 per share). [95] Google’s average analyst estimate for 2015’s EPS is $31.50, while its average analyst estimate for 2014’s EPS is $26.64. [96] Therefore, the average analyst estimate for 1-year EPS growth is 18.24%. [97] Plugging these figures into our equation, we can calculate the Forward PEG Ratio as follows:

Forward PEG Ratio = 29 18.24

Forward PEG Ratio = 1.59

As with its trailing PEG Ratio, this forward PEG of 1.59 suggests that Google’s current share share is not justified by its predicted 1-year EPS growth. In simpler terms, it suggests (but does not confirm) that Google is overpriced at today’s prices. I should make clear at this point that a single tool such as the PEG Ratio is not a sufficient basis on which to definitively conclude that a given company is over/undervalued. Rather, such tools need to be used in combination with others so that the intrinsic limitations of each tool are (partially) compensated for by the strengths of others. Lastly, we should remember that the accuracy of any valuation ratio is dependent on the data plugged into the formulae. If the same conclusion keeps surfacing across a variety of valuation ratios and other tools, then there may be cause for a more definitive conclusion.

→ Inversion to the mean and the law of large numbers

Until until this point, readers may rightly object that the tools we have looked at have been tentative at best. The simple truth of the matter is that there is no reliable method of accurately and consistently predicting the future growth of a specific company’s earnings (at least none that I am familiar with). Thankfully, when we look at the broad overarching history of stock-market movements, certain general trends do emerge which are helpful for our purposes:

1. In general, and all else being equal, PE ratios are inversely related to future price movements. This is one of the general conclusions reached in the Vanguard document which I alluded to earlier. To quote from page 9 of that report, “…valuation measures such as P/E ratios have had an inverse or mean-reverting relationship with future stock market returns.”

2. In general, and all else being equal, rates of earnings growth will tend to revert to their historical average over the medium-to-long term. This is related to the above point.

3. Growing companies eventually face the law of diminishing returns, such that they will eventually struggle to maintain their prior rates of growth. This is far more certain than even the above two points; it is a simple fact of arithmetic that it becomes more difficult to maintain an X% growth rate when the “base” numbers on which one is growing become increasingly large. In the context of finance/investment, this is known colloquially as the “law of large numbers.”

From these three patterns, we can derive the following general conclusions about the relationship between price and earnings:

  1. Investors should be wary of companies whose PE ratios are significantly above either a) their own long-term averages or b) the long-term averages of their industries / competitors (due to points 1 and 2 above).
  2. Investors should be wary of companies whose prices have risen due to remarkable growth in the past. Specifically, investors should question whether that rate of growth is sustainable into the future (due to the law of large numbers).

IV. Consideration of companies’ relative “sex appeal”

Companies’ stock prices are significantly influenced by irrational factors. One such factor is the subjective appeal of the companies for investors. While one often cannot determine what exactly it is about a company which investors find appealing, it is often very easy to infer which companies are currently enjoying a certain “cool factor” and which are not. On a purely subjective level, I would rank our companies—in descending order of perceived “coolness”—roughly as follows:

  1. Google (P/E of 28.06)
  2. Apple (P/E of 14.28)
  3. Microsoft (P/E of 14.94)
  4. Blackberry (no P/E; no net earnings)

I suspect that, as I write this section in May 2014, most readers would roughly agree with this assessment—perhaps while switching the places of Google/Apple or Microsoft/Blackberry. The point here is to question to what extent the performance of each company is likely to be driven by such a fickle and unpredictable thing as the subjective preferences of investors. [98] More specifically, one should be cautious if the company in which one wishes to invest is currently highly “in vogue” among investors. The reason this is a cause for caution is that such sentiments are likely to change, reverting to the mean over time, which could in term negatively affect the company’s price. Conversely, a company with sound business operations which has fallen out of favour among investors may be an interesting candidate for investment.

V. What does Wall Street think?

I don’t pay much attention to Wall Street analysts’ expectations, on the grounds that these expectations tend to be extremely bad predictors of actual future performance. Nonetheless, readers who are curious about Wall Street analysts’ views and recommendations can easily access such information through popular financial websites. For example, here is a comparison of the analyst ratings for Google and Blackberry, compiled from [99]

% of “Buy” Ratings % of “Outperform” Ratings % of “Hold” Ratings # of “Sell” Ratings Average Analyst Rating [100]
Google 64% 0% 36% 0% 4.3
Blackberry 0% 6% 72% 22% 2.6

This data seems to corroborate my own subjective judgment as to the relative “sex appeal” of Google and Blackberry at this time. Skeptical investors should ask themselves to what extent these differing expectations are driven by short-term factors which may be overblown. Seeing that this article has already ballooned to an absurd length, I will save that lengthier analysis for another time.


At the time of publication, Jason Fernando held shares in one of the securities mentioned in this article. Specifically, he held shares in Blackberry, Ltd. He does not intend to trade any of these shares within 48 hours of publication.


[1] The “SEC”, or Securities and Exchange Commission, is the United States governmental body responsible for the regulation of financial markets. To borrow from the “What We Do” section of the SEC website, “The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation” ( One of the foremost roles of the SEC is the collection and public storage of legally-mandated financial disclosure documents. The financial figures used in this chapter are derived from precisely these documents. If you haven’t already, I encourage you to browse through the SEC’s “EDGAR” database in which these documents are stored: (In case you were wondering, “EDGAR” stands for “Electronic Data Gathering, Analysis and Retrieval”).
[2] Of the four companies Graham mentions in the chapter, only one—Emerson Electric—still exists in a publicly traded form.
[3] Minor changes have been made in the formatting of these tables, but all data has been reproduced exactly unless otherwise noted.
[4] 331.
[5] Graham’s footnote on page 331 reads: “Assuming conversion of preferred stock.” On pages 333-334, Graham expands on this point as follows: ““Dilution” note: Emerson Electric had $163 million of market value of low-dividend convertible preferred shares outstanding at the end of 1970. In our analysis we have made allowance for the dilution factor in the usual way by treating the preferred [shares] as if converted into common [stock]. This decreased recent earnings by about 10 cents per share, or some 4%.”
[6] Graham’s footnote on page 331 reads: “After special charges of 13 cents per share.”
[7] 332.
[8] Graham appears to have calculated this figure by subtracting current liabilities from current assets and dividing the resulting figure by Bonds and preferred stock. For example, the calculation for Emerson Electric is as follows: (307,000,000 – 72,000,000) / 42,000,000 = 5.6.
[9] 332.
[10] 27 divided by 2.70 equals 10. Therefore, the price is ten times (10 X) the earnings per share.
[11] 333.
[12] 333.
[13] 333.
[14] A company’s price/earnings ratio is equivalent to its market capitalization per share divided by its earnings per share. For example, ELTRA’s price/earnings ratio is 10, meaning that its market capitalization per share ($216,300,000 divided by 7,714,000) is ten times its earnings per share ($2.70).
[15] 333.
[16] 334.
[17] Companies are not legally obliged to pay dividends to their common shareholders. Therefore, a company which does offer dividends may choose to reduce expenses in tough years by reducing or eliminating those dividends. Companies which can avoid doing so are usually those which are in a strong financial position, enabling them to ‘absorb’ individual bad years and continue paying their dividends.
[18] If you reinvest your dividends into another dividend-paying company, you will set yourself up to benefit from compound interest—the fiscal phenomenon which Albert Einstein famously called “the most powerful force in the universe.” This otherwise questionable-looking website (found doing a haphazard Google search for “compound interest dividends”) hosts a good explanation of how compound interest works with respect to dividends. Given that the company hosting it is a) a money lender and b) knowledgeable about compound interest, I strongly encourage you to run away from this website as soon as you finish reading the explanation!
[19] Reasons “c” and “d” are overlapping, so I’ll address them both here. The interesting thing about dividends is that, all else being equal, they fluctuate inversely with the price of their shares. For example, a company which issues a dividend of $0.25 per share has a 4% dividend yield if its stock costs $6.25 per share (4% of 6.25 = 0.25). If the shares of that same company decline to $4, then its dividend yield increases to 6.25% (6.25% of 4 = 0.25). What this means in practice is that investors that hold stable dividend-paying companies enjoy a kind of “cushion” against market declines; as the price of their shares decreases, the percentage return on their dividends increases in equal and opposite measure. If, at the same time, this hypothetical investor uses her dividends to repurchase shares in those same companies (taking advantage of their newly reduced prices), then she is in a very good position to experience an overall profit over the long-term. In other words, through the prudent use of dividends, such an investor can turn an awful market decline into a long-term investment opportunity. Of course, investors should always remember that the dividends paid on common shares can be cancelled or reduced at any time. Again, this is one of the reasons why Graham values companies with a strong record for uninterrupted dividend payments.
[20] 334.
[21] 335-336.
[22] If your interest in value investing is sustained for any length of time, you will soon encounter the fact that Wall Street analysts are notorious for their rose-coloured perspective on the future prospects of businesses, industries, and the economy as a whole. Like the story of the boy who cried wolf, after a while one just stops listening.
[23] 338.
[24] Of course, this statement will itself be dated before long. For the sake of clarity, this article was written in March of 2014.
[25] Taken from 2013 10-K SEC filings (2013 annual report); will differ from current figures. For example, see footnote 26.
[26] Google’s Form 10-K for the fiscal year ended December 31, 2013 states the following on its title page: “As of January 30, 2014, there were 279,883,488 shares of the registrant’s Class A common stock outstanding and 56,167,343 shares of the registrant’s Class B common stock outstanding.” The figure included above is the sum of these two figures. To refer to this filing, visit: The other Number of shares of common figures are derived in the same manner.
[27] Corporate bond figures derived from
[28] I am using the “Net sales” figure. For more information, see:
[29] Figures in brackets are negative. In this example, the Net income of Blackberry for 2013 was negative; the company suffered a loss of 646 million dollars for the year.
[30] All “Earned per share” figures will feature diluted EPS where applicable. For more information on diluted vs. basic EPS, see:
[31] Shares used in computing this figure: 931,662. To refer to the filing on which this calculation is based, visit:
[32] This figure of $0.76 includes the effect of a two-for-one stock split which was instituted in February 2003. The split decreased 2001 diluted EPS by $0.03.
[33] This figure includes a loss of $0.07 per share for 2001. To refer to this filing, visit:
[34] I am basing this on the assumption that what Graham calls “Net assets for common stock” is equivalent to what is today referred to as “Total Stockholder Equity”. If I am wrong about this, let me know!
[35] This number is arrived at by dividing Net assets for common stock by Number of shares of common. For example, the figure for Google is calculated as follows: $87,309,000,000 / 336,050,000 = $259.81.
[36] On January 29th, 2014, Google instituted a two-for-one stock split. Consequently, readers who are researching the figures provided in this table will find that they differ from current available figures. For more information Google’s stock split, visit For more information on stock splits in general, visit
[37] The price-to-earnings (PE) figure depends on positive earnings per share. Because Blackberry’s earnings per share were negative for 2013, a 2013 PE ratio cannot be provided.
[38] As per footnote 36, the Net/sales, 2013 figure cannot be provided because Blackberry’s 2013 net earnings and earnings per share figures were negative.
[39] See footnotes 37 and 38.
[40] The Working capital/debt ratio cannot be provided because Blackberry has no bonds or preferred stock outstanding. Unless, of course, you wish to divide by zero and arrive at a ratio of infinity (this might prove slightly optimistic…)
[41] See footnotes 37 and 38.
[42] Google’s initial public offering (IPO) took place on August 19th, 2004. For this reason, this figure reflects only the period of August 20th 2004 to December 30th, 2011. This price was registered on September 3rd, 2004.
[43] Microsoft’s IPO took place on March14th, 1986. For this reason, this figure reflects only the period of March 14th 1986 to December 30th, 2011. This price was registered on March 21st, 1986.
[44] Apple’s IPO took place on December 12th, 1980. For this reason, this figure reflects only the period of December 12th, 1980 to December 30th, 2011. This price was registered on July 9th, 1982.
[45] Blackberry’s (NASDAQ) IPO took place on February 4th, 1999. For this reason, this figure reflects only the period of February 4th, 1999 to December 30th, 2011. This price was registered on September 20th, 2002.
[46] This price was registered on December 7th, 2007.
[47] This price was registered on December 23rd, 1999.
[48] This price was registered on October 14th, 2011.
[49] This price was registered on July 20th, 2007.
[50] This price was registered on January 18th, 2013.
[51] This price was registered on January 4th, 2013.
[52] This price was registered on April 19th, 2013.
[53] This price was registered on December 6th, 2013.
[54] This price was registered on February 26th, 2014.
[55] This price was registered on March 18th, 2014.
[56] This price was registered on April 28th, 2014.
[57] This price was registered on January 22nd, 2014.
[58] Blackberry, on the other hand, is not currently profitable. For the sake of simplicity, I have input a percentage value of 0 to indicate their lack of profitability. It would, however, be more accurate to input a negative value in order to reflect the company’s net losses.
[59] Here again, Blackberry’s EPS growth has been input as 0 despite the fact that it has been negative in recent years.
[60] 333.
[61] 333.
[62] Dividend history derived from Microsoft Investor Relations, at:
[63] Dividend history derived from Apple Investor Relations at:
[64] Apple’s first dividend was declared on April 22nd 1987. Since that time, it issued dividends on a quarterly basis until October 6th 1995, at which time it ceased paying dividends until July 24th, 2012. The period from October 6th 1995 to July 24th 2012 represents a period of 64 quarters in which dividends were not paid (4 quarters each for 1996, 1997, 1998, 1999, 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008, 2009, 2010, and 2011). Investors may of course disregard such large gaps in dividend payments in the event that they approve of the company’s reasons for discontinuing their dividend programme. Similarly, readers may object that Apple’s “missed dividends” should not in fact be viewed as a sign of inconsistency or unreliability on the part of the firm, on the grounds that Apple was consistent in their dividend payments within the periods in which they elected to pay dividends at all (from April 22nd 1987 to October 6th 1995; and, subsequently, from July 24th 2012 until the the most recent dividend of April 23rd 2014). This, of course, is a matter of individual judgment.
[65] Data for the S&P 500 PE Ratio and Dividend Yielf averages were derived from and, respectively.
[66] The present time of writing is May 8th 2014.
[67] Google figures are adjusted to compensate for the 2-for-1 share split which occurred on January 29th, 2014. For details, see footnote 36.
[68] Price registered on September 3rd, 2004.
[69] Price registered on February 28th, 2014.
[70] Price registered on March 21st, 1986.
[71] Price registered on December 23rd, 1999. Microsoft’s stock was no doubt propelled upwards as part of the general stock-market euphoria of the late-90s “dot-com bubble.” It is humbling to note that investors who bought into Microsoft at the 1999 market high are still waiting for their shares to recover the plus-$50 figures which they paid. This example goes to show that even great companies can have too high a price. Regardless of how attractive an asset seems, there is always a real risk of overpaying.
[72] Price registered on July 9th, 1982.
[73] Price registered on September 21st, 2012.
[74] Price registered on September 20th, 2002.
[75] Price registered on July 20th, 2007. By August 24th, 2007, the stock’s market price had been reduced to $81.86 per share—a 64.49% decline in only 36 days. This episode is a potent reminder of the severe volatility which occasionally surfaces in financial markets. Depending on the particular situation in question, dramatic market movements of this nature can represent highly attractive investment opportunities.
[76] These figures are accurate as of May 10th, 2014.
[77] The March 2007 shares outstanding figure is derived from YCharts. For details, see:,id:shares_outstanding,,&zoom=10&securities=include:true,id:BBRY,,&recessions=false&units=&maxPoints=926&chartView=&splitType=single.
[78] This chart’s data is accurate as of May 10th, 2014.
[79] The bottom-line conclusion of this research document is that “Most popular metrics have had little or no correlation with future stock returns.” Among the metrics surveyed, P/E ratios are by far the most successful predictors, with Robert Shiller’s Cyclically Adjusted Price-Earnings Ratio (CAPE) the most successful overall. For details, see: Charles J. Thomas, Joseph Davis and Roger Aliaga-Diaz, Forecasting stock returns: What signals matter, and what do they say now? (Vanguard research, October 2012), 7.
[80] Data from
[81] Data from
[82] Data from
[83] Data from Blackberry’s PE figures are not available because the company is not currently profitable. In other words, it is not generating positive earnings.
[84] Data from
[85] Data from
[86] Data from
[87] Data from
[88] Data from
[89] Data from
[90] Data from
[91] Data from
[92] This calculation is based on monthly price data from Yahoo Finance: It is also based on 2013 EPS data from The PE figure is the quotient of the average monthly price and the average EPS for 2013:
[93] The quandary here is that such rapid growth would likely engender further price appreciation, thereby closing the door on future value investors.
[94] Such projections by analysts can once again be found on popular financial websites such as MorningStar and Google/Yahoo Finance.
[95] Data from and This section was written on May 13th, 2014.
[96] Data from Yahoo Finance:
[97] (31.5 – 26.64) / 26.64 = +18.24%  (18.24% growth).
[98] To the extent that the investment decisions of these investors are to any significant extent driven by such “subjective preferences”, we would be wise to refer to them as “speculators” rather than “investors”. Chapter 1 elaborates on this distinction.
[99] Data derived from and, respectively.
[100] Rating Scale: 5=Buy, 1=Sell.