Benjamin Graham is known as the godfather of value investing thanks to his in-depth writing on the topic.
However, when you look back at Graham’s life and times, while he made an enormous amount of money value investing, his best investment was GEICO, a growth stock that helped him and Warren Buffett (Trades, Portfolio) establish the reputation they have today.
“In 1948, we made our GEICO investment and from then on, we seemed to be very brilliant people." -- Benjamin Graham, 1976
Benjamin Graham on growth investing
GEICO wasn’t the only time Graham decided to embrace the growth style. In the fourth edition of his book "Security Analysis," he actually devoted a whole chapter called “Newer Methods for Valuing Growth Stocks” to growth investing, but this was the last edition in which the subject was covered. In the subsequent versions, the chapter was removed.
Graham’s writing on the topic of growth stocks provides some fascinating insight into his thinking:
“In this chapter we propose: (1) to discuss in as elementary form as possible the mathematical theory of growth-stock valuation as now practiced; (2) to present a few illustrations of the application of this theory, selected from the copious literature on the subject; (3) to state our views on the dependability of this approach, and even to offer a very simple substitute for its usually complicated mathematics.”
The initial discussion of the “mathematical theory of growth-stock valuation as now practiced” is as follows:
“The standard method now employed for the valuation of growth stocks follows this prescription. Typically it assumes growth at a relatively high rate—varying greatly between companies –for a period of ten years, more or less. The growth rate thereafter is taken so low that the earnings in the tenth of other “target” year may be valued by the simple method previously described. The target-year valuation is then discounted to present worth, as are the dividends to be received during the earlier period. The two components are then added to give the desired value.”
This approach (similar to a discount cash flow analysis used by Wall Street today) has several issues, which Graham goes on to detail. The most important of these is that the figures rely on a tremendous amount of subjectivity and speculation. This method is also quite complicated and leaves lots of room for error.
So what is Graham and Dodd’s solution to this issue? The book offers two solutions. First is a formula based on the same formula used to compute the estimated value of common stocks generally:
“Our first method endeavored to apply to growth stocks the same basic treatment that we have recommended for common stocks generally, except that we eliminate the dividend factor in the valuation. This means that the value would be found by applying a suitable multiplier to the average earnings for the next seven years. For any expected growth rate this average would be about equal to the middle or fourth year’s earnings.”
The second method is the following equation:
“Value = current “normal” earnings x (8.5 plus 2G), where G is the average annual growth rate expected for the next 7 to 10 years....The specific figures in this formula are derived largely from the concept that a multiplier of 8.5 is appropriate for a company with zero expected growth.”
Both of these formulas seem to be based on the primary growth at a reasonable price equation and Graham’s original method for valuing common stocks whereby earnings over the past seven of 10 years are taken to give an average estimate of earnings potential.
Even though the book does give some insight into how to compute growth stock valuations, it also makes quite clear that the investor should demand an extra premium for uncertainty. The chapter sets out guidance for calculating a range of growth values and subsequent stock valuations, which forms part of the investment process -- undoubtedly with a wide margin of safety applied.
Disclosure: The author owns no stock mentioned.
