In this lecture, Benjamin Graham taught value investing students the correct way to estimate earnings, the right attitude toward projections and the difference between investing and speculating.
Excess capital considerations
Graham examined the SEC's valuation of Childs Company in depth. The SEC assigned a $10 million total value. This included $8.7 million for earnings power and $1.3 million for excess working capital. Graham noted his own "practical" valuation would be $9 million excluding excess capital. He explained excess capital should only be counted if shareholders will receive it, such as via dividends or buybacks. Later the court approved a $9.98 million equity valuation, closer to Graham's assessment. This illustrates how precise valuation of excess assets requires scrutinizing capital return potential.
Observing post-reorganization trading prices provides useful insights. Graham noted Childs' securities initially traded at $8.4 million combined, below the $9.98 million court-approved equity value. He explained this discount was common as the market takes time to gain confidence after major events. But over one to two years, prices tend to normalize closer to intrinsic value. For example, Childs' stock rose from $7 after relisting to $14 in two years. Investors should account for transitional uncertainty when reviewing post-event valuations.
Boom time earnings
Graham warned against extrapolating boom earnings without adjustments. For example, a 1946 report projected American Radiator's earnings tripling from $50 million pre-war to $160 million in 1947 to 1951 based on unsustainably high housing demand. The investor stressed 1948 earnings beyond the boom were unlikely to exceed $100 million. Valuation should concentrate on conservative post-boom earnings, then separately value temporary excess profits.
Even with extensive research, earnings power estimates involve uncertainty. Graham asserted he could value American Radiator in 30 minutes rather than weeks studying industry minutiae. He focused on high-level pre- and post-war earnings comparisons rather than precise projections. While details provide context, investors should avoid false overconfidence in forecasts. Approximating earning power matters more than false precision.
"A thing I would like to warn you against is spending a lot of time on over-detailed analyses of the company’s and the industry’s position, including counting the last bathtub that has been or will be produced; because you get yourself into the feeling that, since you have studied this thing so long and gathered together so may figures, your estimates are bound to be highly accurate. But they won’t be. They are only very rough estimates, and I think I could have given, and probably you could have given me, these estimates in American Radiator in half an hour, without spending perhaps the days, or even weeks, of studying the industry."
Incorporate external data
Leveraging external data provides broader perspective. Graham cited the U.S. Commerce Department and Committee for Economic Development housing demand projections. He advised starting valuation with reputable third-party forecasts, then applying judgment. Relying purely on internal projections risks inherent biases. Reasonable assumptions grounded in external data lead to better valuations.
Distinguishing investment from speculation
Graham distinguished speculation from investment. Speculation targets short-term gains exploiting temporary price swings. Investment values sustainable earnings power. He illustrated with American Radiator – speculative post-war earnings justified a $30 price temporarily, but central value based on normal earnings was only $15 to $18. Previously in 1942, it was even at only $3.75. Monitoring this disconnect guides prudent investment.
An investment-focused valuation may differ from the market's view. For American Radiator, Graham's value based on $1 normalized earnings disagreed with the $20-plus market price reflecting temporarily high earnings. But establishing an objective intrinsic value reference provides discipline against following speculative whims. Standing apart from the crowd is often essential for long-term returns.
He stated clearly for investors to behave intelligently and logically that even high-quality companies can become speculative investments based on their stock price. American Radiator, which despite strong fundamentals, had traded as low as $3.75 per share in 1942 and as high as $30, both share prices could be justified. According to Graham, while the business prospects justify a wide range of potential stock prices, the intelligent investor should determine a central value based on careful analysis. The central value anchors the stock as an investment, while also providing a reference point for speculators looking to capitalize on deviations from fair value. Overall, Graham advocated thorough analysis to establish a stock's central value, which informs investment and speculation based on the company's business fundamentals.
Build valuation models using multiple scenarios to reflect potential variability. Graham suggested optimistic, moderate and pessimistic cases based on differing unemployment level projections. Applying probability weights to each scenario aids disciplined analysis. Avoid false precision from single projections.
Graham generally focused core valuation on a five to seven-year earnings horizon, with exceptions where longer-term industry cycles warrant extension. This balances practicality against the challenges of long-range forecasting. For most businesses, the medium term deserves the most scrutiny to estimate normalized earnings.
In summary, Graham provided timeless and quantitative techniques for prudent security analysis. His advice to focus on normal earning power, leverage external data and craft disciplined scenarios provides durable principles for investment success. By studying Graham, individuals can become better equipped to make rational investment decisions.