Abstract
It is an interesting commentary on human natureand the stock market is a numerical picture of human nature with its hopes and fears-that a great amount of effort and study is usually devoted to the first question, while the second is either given the most cursory treatment or wholly ignored. This difference in emphasis is reflected in the fact that vast numbers of individuals and some 16,000 investment clubs spend tremendous amounts of time and effort trying to find appropriate companies in which to invest. usually rediscovering and reanalyzing statistics on business performance to arrive at opinions on company soundness that could have been acquired from the published ratings and reports of any one of several excellent financial services. On the other hand, so little attention is devoted to trying to find out whether the stock is reasonably priced in relation to its underlying value that only one financial service provides any quantitative approach to this side of the problem, and the timeworn Price-Earnings Ratio with all its crudities and inadequacies is still the accepted criterion for pricing stock purchases. It is the purpose of this article to present an effective statistical yardstick for measuring the underlying value of common stocks as a means of making sophisticated purchase decisions. This procedure is offered, not primarily as a way to make money in the stock market, but rather as a way to keep from losing it. This yardstick or measure of value has resulted from study of a large volume of data on the behavior of common stocks, employing the latest statistical techniques. It was found that a relatively high degree of correlation exists between yearly average stock prices and annual earnings and dividends. By means of a system of ratios, discussed subsequently, it has been possible to generalize the correlation and make it applicable to a wide range of stocks over a considerable period of time. This correlation is expressed by the following equation:
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