The concept of price-earnings ratios for common stocks and the adjustments needed for changes in capitalization are discussed in Chapter 39. According to the chapter, the value of a common stock is typically determined by its current earnings and is measured by a multiplier. Prior to the 1927-1929 bull market, the accepted standard multiplier was ten times earnings. However, this standard was replaced by a confusing set of new yardsticks, with some stocks being valued more liberally than before.
Certain industries, such as public utilities and chain stores, as well as "blue chip" stocks, were sold at very high multiples of current earnings. The chapter acknowledges that security analysis cannot establish general rules for the "proper value" of common stocks because the bases of value are constantly changing. The stock market itself is based on human reactions and decisions, rather than objective measurements. The analyst's role is limited to providing conservative valuation for common stocks, identifying significant factors in the balance sheet that affect earnings, and pointing out the importance of capitalization structure and source of income.
The chapter suggests that the investor's basis of appraisal should be an intelligent and conservative estimate of future earning power, based on actual performance over a period of time. The typical basis of valuation is the average earnings of a company over a period of five to ten years. The chapter proposes that a maximum price for an investment purchase of a common stock should be about 20 times average earnings. It also argues that prices higher than 20 times earnings are speculative and may result in significant financial losses in the long run.
The chapter concludes by stating that an investment-grade common stock should not only have a reasonable ratio of market price to average earnings but also be satisfactory in its financial set-up and management, and have satisfactory prospects. It distinguishes between common stocks of high rating, which it considers speculative due to their high prices, and common stocks suitable for investment, which should have a price substantially less than 20 times average earnings.
Additionally, the chapter categorizes companies into different groups based on their financial positions, earnings records, and market prices. Group A is composed of companies that hail from what are often referred to as "first-grade" industries, entities that were subject to intense speculation during the 1928-1929 market frenzy. They have a strong financial position and presumably good prospects, but their market price is higher than their average earnings justify. On the other hand, Group B consists of companies with unstable earnings records, and their market price varies in relation to average earnings, maximum earnings, and asset values. Group C, which represents a more favorable investment option, consists of companies that meet specific and quantitative tests of investment quality. These companies have reasonably stable earnings, a satisfactory ratio of average earnings to market price, and a conservative financial setup with strong working capital.
When analyzing past earnings on a per-share basis, adjustments must be made for any significant changes in capitalization that occurred during the period. This may involve changes in the number of shares due to stock dividends, split-ups, or additional stock sales at low prices. Adjustments are also necessary for the conversion of senior securities into common stock. Additionally, adjustments must be made when analyzing reported earnings to reflect potential changes in the number of outstanding shares. This adjustment is important because it can significantly impact the per-share earnings of the common stock.
Overall, the chapter emphasizes the importance of making adjustments when analyzing reported earnings and evaluating the intrinsic value of common stock. It highlights the need to consider factors such as changes in capitalization, convertible securities, and participating interests in order to arrive at an accurate valuation.