The Graham & Dodd P/E Matrix
|Based on his observations of stock
over the years, Benjamin Graham developed a stock valuation model that
allows for future growth. Graham observed that the average no-growth
stock sold at 8.5 times earnings, and that price-earnings ratios
increased by twice the rate of earnings growth. This led to the
P/E = 8.5 + 2G
where G is the rate of earnings growth, stated as a percentage.
|The original formulation was made
at a time when there was very little inflation, and growth could be
assumed to be real growth; the AAA corporate bond interest rate
prevailing at the time was 4.4%. In later years, the formula was
adjusted for higher current interest rates that contained an
P/E = [8.5 + 2G] × 4.4/Y
where Y is the current yield on AAA corporate bonds.
|As an example, at a 6% bond yield
and an assumed annual earnings growth rate of 10%, the P/E multiplier
P/E = [8.5 + 2(10)] × 4.4/6
= 28.5 × 0.73
|The Graham and Dodd P/E Matrix uses
this valuation formula to show the price-earnings ratio that results
from a given bond yield at a given rate of earnings growth. You can
see from the table that changes in interest rates will have a dramatic
effect on price-earnings ratios for any given earnings growth rate.