In my opinion, one of the most important determinations that an investor needs to make is the highest price that he is willing to pay for a share in a high-quality business. As is often the case, the work of Benjamin Graham is a great place to begin any journey.
Graham's rule of thumb for determining the maximum price to pay for a security relied on a comparison between the earnings yield of a stock and the yield offered by AAA rated bonds:
Graham suggests one way to determine the maximum acceptable price-earnings ratio is to look at what high-quality bonds are yielding. If bond yields are high, you would want to select stocks selling cheaply-screening for relatively low price-earnings ratios. If bond yields drop, then you could pay more for a stock and therefore screen for stocks with a higher price-earnings ratio. Graham's rule of thumb is to select only those stocks whose price-earnings ratios are less than inverse of double the AAA bond rate. You would double the bond yield and divide the result into 100.
According to Yahoo Finance, the current rate for AAA 10-year corporate bonds is 2.61%. If you double that rate to 5.22%, and if you divide 100 by 5.22, you get 19.15x earnings as the most that the Graham formula would allow. Based on the Graham formula, blue-chip stalwarts like Coca-Cola (NYSE:KO) currently at 21.1x earnings, Colgate-Palmolive (NYSE:CL) at 20.77x earnings, and Procter & Gamble (NYSE:PG) at 21.2x earnings, would be ruled out.
At this time, I think it's important to remember that Graham did most of his research in a world of 5-8% bond rates. When commenting on what he would do if bond rates got uncharacteristically high or uncharacteristically low (like we see now), Graham set these limits on his formula: no matter how high bond rates got, he would always be willing to buy a stock that trades at less than 7x earnings. And no matter how low bond rates got, Graham was not willing to pay more than 10x earnings for any company.
Now, when I do my own research, I've modified the Graham theory a bit to fit my needs. To find stocks that are Graham cheap, you often have to sacrifice earnings quality in the pursuit of cheapness. If I strictly followed Graham and never was willing to pay more than 10x earnings for a stock, I wouldn't have even been able to buy Johnson & Johnson (NYSE:JNJ) and Pepsi (NYSE:PEP) during the financial crisis lows of 2009.
Why does this bother me? Because I agree with Charlie Munger's argument that the big money is made in high-quality businesses, which can go decades without trading below 10x trailing earnings. As he told the students at the USC Marshall School of Business:
We've really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money's been made in the high quality businesses. And most of the other people who've made a lot of money have done so in high quality businesses.
So how do I tweak the Graham formula in a way that will allow me to buy the Cokes and Johnson & Johnsons of the world while still maintaining the standards of reasonable valuation? I take the 30-year treasury rate (I will adjust this to the 10-year treasury rate once bond rates approach the historical normalcy of the 20th century rates) and double it, and then I will refuse to purchase any company that has an earnings yield below that.
For instance, the current 30-year treasury rate is 2.73%. If I double it, I get 5.46%. That means I will only buy high-quality companies that offer an earnings yield above 5.46%. By taking the inverse of that, I get 18.31. This means that, at the current prevailing bond rates, I will never pay more than 18.31x earnings for any high-quality stock, unless I have a very, very compelling reason to do otherwise (namely, the belief that the trailing year's worth of earnings are artificially depressed for a reason I expect to discontinue going forward).
If this methodology appeals to you, I'd like to offer you two important things to keep in mind: I only apply this methodology to the top-quality firms in the world. For example, I wouldn't apply this formula to something like Student Bus Transportation (NASDAQ:STB). Also, I use it as an indicator of the highest price I'd be willing to pay for a top-notch company like Johnson & Johnson or Coca-Cola, so I wouldn't treat it as an automatic indication of a bargain. Warren Buffett once said that it's better to buy a wonderful company at a fair price than a fair company at a wonderful price. This formula is best used for trying to determine the upper end of what a "fair price" for wonderful companies might be.