Intelligent

Intelligent Investing in 2018 – Looking at Valuations

I finished re-reading Ben Graham’s ‘The Intelligent Investor’ earlier this week.  There’s little needs saying about this book, as any investor worth his salt has read it.  Amongst the many, many important concepts and ideas Graham illustrated, one stood out to me that I hadn’t considered before.

The Intelligent Investor

Graham approached his investment philosophy in a very business-oriented way.  His focus was not on macroeconomic events, nor was he a ‘top-down’ investor.  He worked from the ground up, with a view to assessing the individual qualities of each potential business or debt instrument.  Nevertheless, he did refer in places to the various stages of the economic cycle, and certainly understood when valuations on the whole were either egregiously cheap or expensive.  Graham didn’t necessarily believe in timing the market, but he wasn’t stupid.  He knew when to buy, when to hold, and when to move to cash.

There is one brief mention concerning valuation on page 350 of the book that I wanted to explore today.

Valuation – 1972

“Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/price ratio – the reverse of the P/E ratio – at least as high as the current high-grade bond rate.  This would mean a P/E ratio no higher than 13.3 against an AA bond yield of 7.5%.” – Ben Graham – The Intelligent Investor

So there is Ben Graham’s formula for valuation, writing in the early 70’s when bond yields were far more appealing than they are today.  Jason Zweig, who wrote the commentary for my edition of the book, updated this in 2003 showing a yield of 4.6%.  This would establish a maximum P/E ratio in the early years of the 21st century of 21.7.

With bond yields today lower than possibly any point in history, what would be the maximum ratio for UK stocks at present?

Valuation – 2018

To establish this, we need two pieces of information.  One, the current yield on AA rated UK corporate debt, and two, the current P/E ratio for the UK.

We can work out the earnings-to-price ratio by dividing 100 by the current bond rate.  If we take the par-weighted figure, this works out at a maximum P/E ratio of 29.85.  If we use the yield-to-maturity we get a staggering 51.81!

What does this tell us?  Based on Graham’s formula, the UK equity market is most definitely undervalued on a P/E of 17.1 at the time of writing.  If we consider current yields obtainable on investment-grade debt, the balance is clearly in favour of a higher weighting towards holding and indeed adding to investment in UK listed companies.  As ever, please do your own research.

Happy investing!

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2 thoughts on “Intelligent Investing in 2018 – Looking at Valuations”

  1. On the other hand bond yields coud rally north of 5% ( ie “normal” levels) and UK stock prices should not be affected too much.

    Cant help thinking that its bonds which are wrongly priced and not stocks.

  2. Chris
    Great spot. I am ashamed to say that despite having been proactively investing for well over a decade I haven’t read the II but relied on people like you to pick these nuggets out!
    However there are two things that might prevent the 7.5% being directly comparable with today’s yields. First is inflation. Interestingly it wasn’t much higher in 1971 (3.3%) as it is now but maybe expectations were different then . The other issue might be liquidity. The corporate debt market was around $450bn back in 1980 (so presumably even smaller in 1971) – that’s approx $2.8trn at today’s prices. Market size is over $9trn today
    Nevertheless this read across on valuations is another thing to consider when unnecessarily fretting over whether we are holding enough cash
    Cheers
    Stephen

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