Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

CHAPTER 1

TWO ILLUSTRATIVE APPROACHES TO FORMULA VALUATIONS OF COMMON STOCKSa

Benjamin Graham

Two common-stock valuation approaches are examined in detail. The first approach considers company profitability, earnings growth and stability, and dividend payout. It derives an independent value of a stock that is then compared with the market price. In contrast, the second approach starts with the market price of a stock and calculates the rate of future growth implied by the market. From the expected growth rate, future earnings can be derived, as well as the implicit earnings multiplier in the current market price. Both approaches demonstrate that the market often has future growth expectations that cannot be derived from companies’ past performance.

Of the various basic approaches to common-stock valuation, the most widely accepted is that which estimates the average earnings and dividends for a period of years in the future and capitalizes these elements at an appropriate rate. This statement is reasonably definite in form, but its application permits of the widest range of techniques and assumptions, including plain guesswork. The analyst has first a broad choice as to the future period he will consider; then the earnings and dividends for the period must be estimated, and finally a capitalization rate selected in accordance with his judgment or his prejudices. We may observe here that since there is no a priori rule governing the number of years to which the valuer should look ...