Any estimate of earning power extending over future years may easily fall wide of the mark, since the major business factors of volume, price, and cost are all largely unpredictable.
Assuming that profits develop as anticipated, there remains a similar doubt as to whether the multiplier, or capitalization rate, will prove correctly chosen.
A valuation may be very skillfully done in the light of all the pertinent data and the soundest judgement of future probabilities; yet the market price may delay adjusting itself to the indicated value for so long a period that new conditions may supervene and bring with them a new value. Thus even though the price ultimately converges with that new value, the old valuation may have proved undependable.
These handicaps that are attached to the value approach should be clearly recognized by the analyst, and they should make him modest and circumspect in its use. In particular he must use good judgement in distinguishing between securities and situations that are better suited and those that are worse suited to value analysis. Its working assumption is that the past record affords at least a rough guide to the future. The more questionable this assumption, the less valuable is the analysis.
Hence this technique is:
- more useful when applied to senior securities (which are protected against change) than to common stocks;
- more useful when applied to a business of inherently stable character than to one subject to wide variations; and , finally,
- more useful when carried on under fairly normal general conditions than in times of great uncertainty and radical change.
There are three general areas in which value analysis will operate most successfully.
1. That of inherently stable securities. These include
- good quality bonds and preferred stocks, and also – because of the nature of the industry –
- the common stocks of conservatively capitalized public utilities, and perhaps of the strongly entrenched industrial and railroads as well.
2. This includes cases of extreme disparity between price and indicated value. Here the analyst relies upon a large initial margin of safety to absorb and offset the uncertainties of the future. In this area the insurance principle of diversification, or spreading of risk, is especially valuable.
3. Finally, there is the field of comparative analysis. Where the securities studied are corporately related or are affected by closely similar conditions, it may often be possible to reach a reliable and useful conclusion that one is preferable to the other.
Source: Graham's Security Analysis
The Estimate of Future Earning Power
Analytical Judgments in Value Analysis
Securities Not Suited to Valuation Analysis