The BV Story

ben graham

Benjamin Graham

In 1949 we could present a study of stock-market fluctuations over the preceding 75 years, which supported a formula — based on earnings and current interest rates — for determining a level to buy the DJIA below its “central” or “intrinsic” value, and to sell out above such value. It was an application of the governing maxim of the Rothschilds: “Buy cheap and sell dear.” And it had the advantage of running directly counter to the ingrained and pernicious maxim of Wall Street that stocks should be bought because they have gone up and sold because they have gone down. Alas, after 1949 this formula no longer worked.
BENJAMIN GRAHAM, The Intelligent Investor

warren buffett

Warren Buffett

On a macro basis, quantification doesn’t have to be complicated at all. Below is a chart, starting almost 80 years ago and really quite fundamental in what it says. The chart shows the market value of all publicly traded securities as a percentage of the country’s business – that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment. And as you can see, nearly two years ago the ratio rose to an unprecedented level. That should have been a very strong warning signal.
WARREN BUFFETT, Warren Buffett on the Stock Market

Idid not set out to discover my own valuation metric. In the beginning, my intention was only to reconstruct the price/GNP ratio that Warren Buffett introduced in a 2001 Fortune article, because it seemed to be a better indicator than the common PE ratio, especially at key market turning points.

buffett's metric 2001

Chart of Buffett’s metric from his December 2001 article in Fortune.

I immediately ran into problems getting data for the market value of all publicly traded securites. GDP data was available back to 1790, but market value data from the Federal Reserve went back only to 1945, and it was annual data at that. As a substitute I toyed with the Wilshire 5000, but soon found out that the series began in 1970, not far back enough to be helpful.

Then it hit me. Why not use the S&P 500 index to stand in for the market value of all publicly traded securities? After all, the S&P is a capitalization-weighted index, and it represents about three-quarters of the total stock market. And data was available from 1950 courtesy of Yahoo! Finance. For earlier prices, I could use the data Robert Shiller generously provided at his website.

From that point it was a trivial matter to calculate the ratio of market price to GDP all the way back to 1919.

buffett's metric 2009

Buffett’s metric updated by Fortune in early 2009, then at a level that suggested it was time to buy.

Adjusting for interest rates
As Jason Zweig said, a PE ratio is a simple tool for taking the market’s temperature. A little too simple, in practice. For one thing, the price/earnings ratio gives misleading readings of market value when earnings are depressed or conversely, when earnings are at peak levels. In these cases, PE will tell you the opposite of what you need to hear. It will tell you the market is expensive when earnings collapse in a recession, or that the market is cheap when earnings soar in an overheated economy.

To overcome this problem, Ben Graham recommended that investors normalize earnings by using a seven-year average. Similarly, Robert Shiller’s cyclically-adjusted price/earnings ratio uses a ten-year average. But smoothing out earnings is only part of the job.

Ben Graham also adjusted PEs to account for varying growth rates and bond yields. This I had learned in the 1980s from one of the first investing guides I owned. Because Ben’s rule of thumb made it easy to determine the fair value of a given stock, it quickly found its way into my valuation toolbox.

Taking this familiar rule out of the toolbox once again, I simply multiplied the ratio of market price over GDP by the prevailing medium-term corporate bond yield to arrive at an interest rate-adjusted value I call PYi, explained in detail here.

understanding wall street

Page 116 and 117 of Understanding Wall Street, by Jeffery Little and Lucien Rhodes, where the authors discuss Graham & Dodd’s PE formula. Click image to enlarge.

It’s not what you say, it’s how you say it
A huge insight landed in my lap one day in 2007 when reading through Carl Swenlin’s excellent Decision Point site (now part of StockCharts).

carl swenlin

Carl Swenlin

On a chart of the S&P 500, Carl had plotted three PE lines, the central one representing fair value and two others for extremes of over and undervaluation. To calculate their values, he held the PE constant and solved for price. This technique immediately reminded me of the original Value Line, a multiple of cash flow drawn on a price chart, one I had studied for more than twenty years in pursuit of undervalued stocks.

I knew right away this was the breakthrough I needed, but I still wasn’t aware it was the key to the castle.
decision point pe range

The Decision Point chart that pointed me in the right direction. Here is the S&P is shown in relation to its normal PE range, with a PE of 10 representing undervalue and a PE of 20 representing overvalue, with fair value at a PE of 15.

Hello, Brock Value
So equipped with the long range data I needed, the interest rate adjustment and an elegant way to visualize the data, Brock Value just fell into place. In an instant, I could see I had stumbled upon an important indicator. The S&P 500, superimposed on the BV line, tracked it closely, diverging from time to time, but always returning to a now-visible center of one standard deviation

In the beginning, the upper and lower range lines were set one standard deviation in each direction. I decided later that a third of this distance made a better indicator of extreme valuations. Click image to enlarge.

Later, I compared BV to other ratios – price/earnings, price/dividend and three other classic metrics – only to come away even more convinced.

BV’s inherent limitations
It’s not as well understood as it should be, but any yardstick you use to measure the stock market’s valuation will produce a definite answer and an ambiguous course of action. One reason to be cautious, as Ben Graham found, is that the past and present can disagree. What one generation of investors considers a normal valuation is only a reflection of their experience and the dominant social mood. In other words, because the market looks back at itself to set the standard, it can fall prey to mispricing. This abnormal valuation can persist for many years.

There is nothing more
deceptive than
an obvious fact.

Second, stock market valuation is deceptive. Investors hope for simple rules they can follow to stay out of trouble and earn good returns. But when they obey valuation yardsticks blindly, what they get instead are misdirections, because valuation is but one measure of the market – one the market itself frequently ignores. I cover the gamut of valuation pitfalls here.

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4 responses to “The BV Story”

  1. john Constable

    Peter…I’m wondering whether you should use rsp instead of spx as a proxy for Warren’s “market value of all securitities”. The other variable I am trying to puzzle through is to think about gdp ex excess fed spending above a 3% deficit.

  2. Pete Brock

    Thanks for the two interesting ideas. About the Guggenheim S&P 500 Equal Weight ETF, not surprisingly it is highly correlated with the S&P Mid Cap 400 Index. That’s probably not what Buffett had in mind. So as a broad market proxy and given its long data history, we have to give the S&P 500 the nod.

    You could modify GDP numbers as you propose. My philosophy here is to take the data at face value and keep things seriously simple for the sake of utility. But let me know if you carry out this study. I’d be interested in the results.

  3. charles

    why divide by 2 in your formula?

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