Reading through Security Analysis, the roadmap for investing first published in 1934 by Benjamin Graham and David L. Dodd, I learned something quite interesting: The basis of stock valuation had changed quite drastically in the period between 1927 and 1929. The stock buying public “departed more and more from the factual approach and technique of security analysis and concerned itself increasingly with the elements of potentiality and prophecy”, write Graham and Dodd.1
What they mean is that in the pre WWI world, stocks were typically valued on the basis of a three-part concept: (i) a decent track record of firms’ dividend returns, (ii) a stable and satisfactory earnings record, and (iii) a strong balance sheet, with sufficient backing by tangible assets. The “New-Era” theory of stock valuation reads, summarized in one sentence, as follows: “The value of a common stock depends entirely upon what it will earn in the future.”
Current dividends should only have a slight impact upon a stock’s valuation, and as firms’ asset values did not have an apparent relationship with their earning power, asset values were said to be devoid of importance when it comes to calculating a stock’s “fair price.” A firm’s earnings record was only relevant to the extent that it might indicate what changes in a firm’s future earnings were likely to be expected. In other words, the New-Era theory of stock valuation was quite a break compared to the valuation technique employed in the past.
A Sea Change in Pricing Stocks
According to Graham and Dodd, there were two significant causes why such a change in the approach to stock valuation occurred. First, accounting data of a firm’s past proved to be increasingly unreliable as a guide for making wise investment decisions. The reason for this was rapid changes in demand structures and product and process technologies. Second, the expectation of future rewards became increasingly attractive to many investors, in fact, “irresistibly alluring.”
The New-Era theory of stock valuation, which people followed in the hot phase of the 1927-1929 stock market rally, turned out to suffer from two weaknesses, according to Graham and Dodd. First, it encouraged people to speculate heavily: stock prices were driven by expected future profits, detached from “the facts of the established past.” Second, established standards of valuation were thrown overboard. Any prevalent valuation level could easily be interpreted to be the new standard of valuation.
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