Tuesday, November 20, 2007

common stock prices and values

This is taken from Benjamin Graham's book the interpretation of financial statements chapter 33
Broadly speaking, the price of common stocks is governed by the prospective earnings. These prospective earnings are, of course, a matter of estimate or foresight; and the action of the stock market on this point is usually controlled by the indicated trend. The trend is gauged in turn from the past record and current data, although at times the expectation of some quite new development will pay a determining part.
The price of common stocks will depend, therefore, not so much on past or current earnings in themselves upon what the security buying public thinks the future earnings will be. (there are also important influences of a general or technical nature affecting stock prices-such as credit, political, and psychological conditions-which may not be closely related to any estimate of future earnings; but such influences will either eventually reflect themselves in the earnings or else prove to be quite temporary.)
In the ordinary case the price of a common stock is the resultant of many estimates of what the earnings are going to be in the next six months, in the next year, or even further in the future. Some of these estimates may be entirely incorrect and some may be exceedingly accurate; but the buying and selling by the many people who make these various estimates is what mainly determines the present price of a stock.
The accepted idea that a common stock should sell at a certain ratio to its current earnings must be considered more the result of practical necessity than of logic. The market takes the trend or future prospects into account by varying this ratio for different types of companies. Common stocks of enterprises with only slight possibilities of increasing profits ordinarily sell at a rather low price-earning ratio(less than 15 times their current earnings); and the common stocks of companies with good prospects of increasing the earnings usually sell at high price-earnings ratio (over 15 times the current earnings). Thus, two common stocks may show the same current earnings per share, may be paying the same dividend rate, and be in equally good financial condition. Yet stock ABC may be selling at twice the price of stock XYZ simply because security buyers believe that stock ABC is going to earn a good deal more than XYZ next year and the years after.
When neither boom nor deep depression is affecting the market, the judgment of the public on individual issues, as indicated by market prices, is usually quite good. If the market price of some issue appears out of line with the facts and figures available, it will often be found later that the price is discounting future developments not then apparent on the surface. There is, however, a frequent tendency on the part market to exaggerate the significance of changes in earnings both in a favorable and unfavorable direction. This is manifest in the market as a whole in periods of both boom and depression, and it is also evidenced in the case of individual companies at other times.
At bottom the ability to buy securities-particularly common stocks-successfully is the ability to look ahead accurately. Looking backward, however carefully, will not suffice, and may do more harm than good. Common stock selection is a difficult art-naturally, since it offers large rewards for success. It requires a skillful mental balance between the facts of the past and the possibilities of the future.

No comments: