Open Collections

UBC Theses and Dissertations

UBC Theses Logo

UBC Theses and Dissertations

The effect of price earnings ratio on investment decisions in trusteed pension plans Thurgood, Mervyn Frederick 1972

Your browser doesn't seem to have a PDF viewer, please download the PDF to view this item.

Item Metadata

Download

Media
831-UBC_1973_A4_5 T48.pdf [ 8.61MB ]
Metadata
JSON: 831-1.0101207.json
JSON-LD: 831-1.0101207-ld.json
RDF/XML (Pretty): 831-1.0101207-rdf.xml
RDF/JSON: 831-1.0101207-rdf.json
Turtle: 831-1.0101207-turtle.txt
N-Triples: 831-1.0101207-rdf-ntriples.txt
Original Record: 831-1.0101207-source.json
Full Text
831-1.0101207-fulltext.txt
Citation
831-1.0101207.ris

Full Text

c THE EFFECT OF PRICE EARNINGS RATIO ON INVESTMENT DECISIONS IN TRUSTEED PENSION PLANS by Mervyn F. Thurgood B. Com., R.I.A., psc. UNIVERSITY OF BRITISH COLUMBIA A THESIS SUBMITTED IN PARTIAL FULFILMENT THE REQUIREMENTS FOR THE DEGREE OF MASTER OF BUSINESS ADMINISTRATION in the Department of COMMERCE AND BUSINESS ADMINISTRATION We accept t h i s thesis as conforming to the required standard THE UNIVERSITY OF BRITISH COLUMBIA September 1972 In presenting this thesis in partial fulfilment of the requirements for an advanced degree at the University of British Columbia, I agree that the Library shall make i t freely available for reference and study. I further agree that permission for extensive copying of this thesis for scholarly purposes may be granted by the Head of my Department or by his representatives. It is understood that copying or publication of this thesis for financial gain shall not be allowed without my written permission. Department of. The University of British Columbia Vancouver 8 , Canada i i A B S T R A C T THE PROBLEM To what extent does the Price to Earnings Ratio a f f e c t the investment decisions of those who manage Trusteed Pension Funds i n Canada? Secondly: What are the damgers of ignoring t h i s index when trading i n common stocks for pension plans? METHODOLOGY A complete study of Canadian pension funds and the methods of funding was made i n order to get a thorough understanding of pensions i n Canada. Trusteed pensions f a l l into two categories: - the Money Purchase Plans. - the Definite Benefit Plans. The Trusteed pension was studied from the point of view of costs and benefits, emphasizing the importance of investment y i e l d s . A study of the Price Earnings Ratio per se., was made. The study includes the examination of accounting methods used to determine earnings per share. The next step was to determine and understand the rela t i o n s h i p of the Price Earnings Ratio to corporate growth. A further step was to determine the variables contributing to sustained corporate growth. A study of the usefulness of the Price Earnings Ratio as a valuation t o o l was made, based on the works of leading writers i n t h i s f i e l d . The use made of the Price Earnings Ratio by investment managers i n practice was examined, as well as the whole decision making process. This was achieved through personal interviews and by questionnaires. From the information received, a summary was prepared on the decision making process and the role of the Price Earnings Ratio i n that process. Various data concerning pension p o r t f o l i o stocks, Price Earnings Ratios and performance, was co l l e c t e d and summarized i n the appendices. CONCLUSIONS It was concluded that: - Considering the cost of a pension, the two most important variables are expense and earnings; of the two, investment y i e l d or earnings has the greatest e f f e c t on reducing costs. - In determining earnings per share, not only primary E.P.S. but also f u l l y d i l u t e d E.P.S. should be determined and compared. - The Price Earnings Ratio i s a concept consistent with the present value formulae and assumes combinations of earnings, growth, duration, discount and dividend payouts. I t i s important that investment managers understand t h i s . - Sustainable growth i s dependent primarily on margin, turnover, leverage and taxes. - S t a t i s t i c a l studies have shown that low Price Earnings Ratio stocks consistently outperform high Price Earnings Ratio stocks. - The decision making process places great emphasis on Fundamental Analysis and the Price Earnings Ratio. - When considering the Price Earnings Ratio, the analyst w i l l study i t i n r e l a t i o n to the popular indices, other companies i n the industry and i n r e l a t i o n to the companies projected growth rates. RECOMMENDATIONS Unless there i s strong evidence to the contrary, a stock with a low Price Earnings Ratio should be purchased i n preference to a stock with a high Price Earnings Ratio, p a r t i c u l a r l y i f the stock meets these conditions: - A consistently high earnings record i n past years. - There i s no evidence of an earnings decline i n future years. - The qu a l i t y of management i s high. - There i s a r e l a t i v e l y high margin and turnover. TABLE OF CONTENTS CHAPTER Page I INTRODUCTION 1 Organization 1 Methodology 3 Conclusions 5 Recommendations 8 Contributions 10 II PENSION FUNDS IN CANADA 12 The Insured Method and Trusteed Method 12 Where the Cost i s Known 13 Where the F i n a l Benefit i s Known 15 III THE IMPORTANCE OF INVESTMENT YIELD 21 IV DETERMINING EARNINGS PER SHARE . 27 Background 27 Determination of Primary E.P.S. 30 Determination of F u l l y Diluted E.P.S. 35 V PRICE EARNINGS RATIO AND ITS RELATIONSHIP TO CORPORATE GROWTH 37 The P/ER and the Present Value Vormulae 38 Modification of the Model 41 Application 44 Conclusion 46 VI THE CONCEPT OF SUSTAINED GROWTH 4 7 The Basic Equation 4 8 The E f f e c t of Leverage 52 The E f f e c t of Income Taxes 54 Return on Common Equity 54 Changes i n Earnings per Share 55 Changes i n Book Value 56 Conclusion 57 A Numerical Example 58 VII THE USEFULNESS OF THE PRICE EARNINGS RATIO IN THE VALUATION OF STOCKS 61 Introduction 61 Market or Industry P/E Ratio Comparison 62 7 1 TABLE OF CONTENTS - continued: CHAPTER Page VII Continued: Current or Normalized Earnings 66 P/E Ratio as a Measure of Growth 6 8 Valuation of Stocks Using P/E Ratios 75 Conclusion 79 VIII THE QUESTIONNAIRE, RESULTS AND FINDINGS .... 81 The Questionnaire 81 The Scope of the Questionnaire 81 The Findings 8 3 Company A 8 3 Company B 8 6 Company C 88 Company D 90 Company E 93 Company F 96 The Investment Decision Making Process 98 IX SUMMARY 106 v i i LIST OF: FIGURES, EXHIBITS, TABLES, EXAMPLES AND ANNEXES Figure 3.1 Exhibit 4.1 Exhibit 4.2 Exhibit 4.3 Exhibit 4.4 Exhibit 4.5 Table 1 A Table 1 B Table II Exhibit 6.1 Exhibit 6.2 Example 6.1 Table 7.1 Table 7.2 Annex 8.A Annex 8 B.l Annex 8 B.2 Annex 8 B.3 Annex 8 B.4 Annex 8 B.5 The E f f e c t of Investment Yields. Presentation of P/ER Share Data Terminology Primary EPS Determination when Convertible Debt i s Outstanding After Page 26 Page 2 3 Page 24 After Page 36 Examples of Primary EPS Determination where Warrants are Outstanding After Page 36 Procedure for Alternative Schedule of Diluted EPS. After Page 36 P/E Ratio and Corporate Growth b=0 After Page 46 P/E Ratio and Corporate Growth b = 1 A f t e r P a& e 46 Application Page 45 The DJIA Ratio Analysis of 1965 Earnings „ r n x After Page 60 Sustainable Growth Based on 1954-1965 Data After Page Numerical Example Page 49 Price-Earnings Ratios on Standard and Poor's Stock Price Indexes Page 52 Price-Earnings Ratios of Selected Companies 1961-1965 Page 53 The Questionnaire Page 117 Investment P o r t f o l i o s of Company A, Page 120 1969 - 1970 Investment Portfolios of Company B, Page 122 1969-1970 Investment P o r t f o l i o s of Company C, Page 124 1969-1970 Investment P o r t f o l i o s of Company D, Page 127 1969-1970 Investment P o r t f o l i o s of Company D, Page 129 1969-1970 ANNEXES - continued: y i ' i i Annex 8.C Table":of Results of Questionnaire P a S e 151 Annex 8.D Relative Performance of Trust Company Page 132 Pooled Pension Funds Annex 8.E Summary of Compound Rate of Return Page 133 Annex 9.A Miscellaneous Data and Other Nothings. Page 134 CHAPTER I INTRODUCTION This Thesis i s intended to focus attention on how the Price to Earnings index affects the investment decisions of those who manage Trusteed Pension Funds i n Canada. Secondly, the Thesis w i l l attempt to make the reader aware of the dangers of ignoring the Price Earnings Ratio when trading i n common stocks. ORGANIZATION Chapter I I : describes the various types of Pension Funds i n Canada and d i f f e r e n t i a t e s between the Insured and the Trusteed methods of funding pension plans. In t h i s chapter the various types of Plans are des-cribed and are divided into two broad categories. F i r s t , where the cost i s known but the benefit i s not, and secondly, where the benefit i s known and the cost i s not. The following plans are described: The Money Purchase Plan The Definite Benefit Plan including: a) The F l a t Benefit Plans b) The Unit Benefit Plans. Chapter I I I : describes the costs of a Pension Plan and i t s re-l a t i o n to investment y i e l d s . It indicates some of the dangers that can arise when too much emphasis i s placed on comparing the - 2 -performance of various investment y i e l d s . Chapter IV: focuses the attention of the reader on the account-ing procedures now being employed to determine earnings per share and to impress upon the reader that earnings per share de-pend to a great extent on the accounting procedure used. Hence, to compare the Price Earnings Ratios of s e c u r i t i e s , the invest-ment manager should use a common method for determining earnings per share. Chapter V: describes the Price Earnings Ratio and i t s r e l a t i o n -ship to corporate growth and associates the P/ER and the Present Value Formula. This chapter focuses the attention of the reader on the assumptions behind the value of each Price Earnings Ratio and stresses the importance of understanding how price earnings rat i o s are determined i n the market. Chapter VI: discusses sustained growth and the role the price earnings r a t i o and earnings per share are now playing i n Fundam-ental Analysis i n determining stock p r i c e s . Six variables that a f f e c t changes in earnings per share are discussed and elements contributing to sustainable growth are i s o l a t e d from those con-t r i b u t i n g to earnings growth. Chapter VII: discusses the results of emperical studies compar-ing the long term y i e l d s on low P/E r a t i o stocks and high P/E r a t i o stocks. This chapter further discusses the usefulness of the P/E r a t i o as a valuation t o o l , based on the studies of leading writers i n t h i s f i e l d and indicates the l i m i t a t i o n s of - 3 -P/E r a t i o s i n stock s e l e c t i o n . Chapter VIII: describes the method of obtaining emperical e v i -dence to determine the investment management process and the role played by the Price-Earnings Ratio i n that process. The chapter contains an outline of the questionnaire used, the findings ob-tained and a description of the decision making process common to most Trust Company Investment Managers. Chapter IX: This i s the concluding chapter which summarizes the study, with p a r t i c u l a r emphasis on: the d i f f i c u l t i e s i n determin-ing earnings per share, Price Earnings Ratio and Corporate Growth, the use of the P/E r a t i o as a valuation t o o l and i t s use i n s e l -ecting equities for Pension Fund P o r t f o l i o s . METHODOLOGY In order to accomplish our aim, a complete study of pension funds must be made and the methods of funding pension plans must be c l e a r l y understood. This was accomplished by actual employment i n pension departments and a study of Trust Company, Insurance Company and Banking Firms, pension brochures. Two well prepared publications on Employee Benefits i n Canada were also used, Canadian Handbook of Pension and Welfare Plans by William M. Mercer Limited, CCH Canada Ltd. 1967, and A Study of Canadian Pension Plans published by The National Trust Company. When a thorough understanding of the nature of Pensions i n Canada was gained, the trusteed type was studied from the point of view of costs and benefits and the importance of invest-- 4 -ment y i e l d s t o t h e T r u s t e e d Type Fund. Views and comments on i n v e s t m e n t performance were s t u d i e d and c o n c l u s i o n s r e a c h e d as t o t h e i r v a l i d i t y . A s t u d y o f t h e P r i c e E a r n i n g s R a t i o p e r se. was made. T h i s p a r t o f t h e s t u d y o f n e c e s s i t y was based p r i m a r i l y on ac-c o u n t i n g methods and p r i n c i p l e s u s u a l l y beyond t h e knowledge o f most i n v e s t m e n t managers. They d e a l w i t h such a c c o u n t i n g p r o -cedures as the C u r r e n t O p e r a t i n g Concept as opposed t o t h e A l l I n c l u s i v e Concept, a l s o t h e y d e t e r m i n e what c o n s t i t u t e s p e r share e a r n i n g s and how p e r share d a t a s h o u l d be d e t e r m i n e d . The l o g i c a l s t e p i s now t o determine and u n d e r s t a n d t h e r e l a t i o n s h i p o f t h e P r i c e E a r n i n g s R a t i o t o c o r p o r a t e growth and how t h e market might a r r i v e a t a c e r t a i n P r i c e E a r n i n g s R a t i o . T h i s s t u d y i n c l u d e s t h e r e l a t i o n s h i p o f t h e P/E r a t i o and t h e P r e s e n t V a l u e F o r m u l a , from w h i c h a model i s d e v e l o p e d . A s t u d y o f the use o f the P/E r a t i o as a v a l u a t i o n t o o l was made based on papers by l e a d i n g s w r i t e r s i n t h i s f i e l d t o de-t e r m i n e r e s u l t s t h a t would have been a c h i e v e d by i n v e s t i n g i n h i g h P/ER s t o c k s when compared w i t h i n v e s t m e n t s i n low P/ER s t o c k s . T h i s i s i n essence a "what i f " s t u d y o f i n v e s t m e n t s e l e c t i o n s based e n t i r e l y on t h e P/E R a t i o . Having a t h o r o u g h u n d e r s t a n d i n g o f T r u s t e e d P e n s i o n P l a n s , t h e i r c o s t , t h e i m p o r t a n c e o f i n v e s t m e n t y i e l d t o t h e c o s t o f a p e n s i o n , t h e method o f d e t e r m i n i n g e a r n i n g s per s h a r e , - 5 P r i c e Earnings r e l a t i o n t o c o r p o r a t e growth and the t h e o r e t i c a l u s e f u l n e s s o f the P/ER i n making investment d e c i s i o n s , a study-was made of the use of the P/ER i n p r a c t i c e s ; t h i s was achieved by p e r s o n a l i n t e r v i e w s w i t h investment managers, q u e s t i o n n a i r e s sent out to t r u s t and other investment c o u n s e l l o r s and i n v e s t -ment f i r m s i n the area. From the i n f o r m a t i o n r e c e i v e d a summary was prepared on the d e c i s i o n making process and the r o l e o f the P/E r a t i o i n t h a t p r o c e s s . A review o f the p o r t f o l i o s h e l d by each pension fund was made comparing t h e i r p o r t f o l i o P/ER and t h e i r performance. C o n c l u s i o n s and recommendations were then developed. CONCLUSIONS The c o s t o f a Pension P l a n i s : (1) The t o t a l c o s t o f a l l b e n e f i t s p a i d out Plus (2) The a d m i n i s t r a t i v e expenses Minus (3) The amount of employee c o n t r i b u t i o n s Minus (4) The earnings o f the fund. Of the two v a r i a b l e s expense and earnings o f the fund the earn-ings o r investment y i e l d has the g r e a t e s t e f f e c t i n red u c i n g c o s t s . Hence the investment y i e l d becomes extremely important. - 6 -Determining Earnings Per Share When e v a l u a t i n g earnings per share o f fi r m s w i t h complex c a p i t a l s t r u c t u r e s , the a n a l y s t should determine not o n l y primary E.P.S. but a l s o f u l l y d i l u t e d E.P.S. i n order t o make comparisons and v a l u a t i o n s meaningful. The P r i c e Earnings R a t i o : i s a concept c o n s i s t e n t w i t h the p r i n -c i p l e s o f presen t value theory, d e r i v e d from the presen t value formulae and assumes s p e c i f i c combinations of valu e s f o r earn-ings growth, d u r a t i o n , d i s c o u n t r a t e s and d i v i d e n d payout. T h e r e f o r e , investment managers and s e c u r i t y a n a l y s t s should f o -cus on the assumptions behind the value of each P r i c e - E a r n i n g s r a t i o w h i l e the u l t i m a t e d e c i s i o n s and p r i c e p r o j e c t i o n s w i l l always be i n the s u b j e c t i v e , t h e i r r e l a t i o n s h i p t o the i m p l i e d or expressed assumptions can be e v a l u a t e d o b j e c t i v e l y . S u s t a i n a b l e Growth: i s a f u n c t i o n o f earnings per share which i n t u r n depends on s i x v a r i a b l e s and changes i n those v a r i a b l e s : M - Margin T - Turnover L - Leverage U - Tax r a t e s B - E x t e r n a l f a c t o r s which a f f e c t Book Value R - Rete n t i o n r a t e . The f i r s t f our v a r i a b l e s are key v a r i a b l e s , which w i l l p r e c i p i t a t e f l u c t u a t i o n s i n the earnings stream as w i l l e x t e r n a l - 7 -f a c t o r s . Only the r e t e n t i o n r a t e can be regarded as a s u s t a i n -able source of growth. T h i s growth i s o n l y s u s t a i n a b l e to the extent margin, t u r n o v e r , leverage and taxes are maintained at c u r r e n t l e v e l s . There i s no guarantee f o r the f u t u r e although a look at the h i s t o r i c a l values of M, T, L and U may h e l p d e f i n e the nor-mal e a r n i n g power of the company. The P r i c e Earnings R a t i o Three s i g n i f i c a n t s t a t i s t i c a l s t u d i e s have shown low P/E r a t i o s e c u r i t i e s have c o n s i s t e n t l y outperformed h i g h P/E r a t i o s t o c k s . A h i g h P/E r a t i o i s a poor i n d i c a t i o n of h i g h f u t u r e growth. The e v a l u a t i o n method can be u s e f u l i n determining whether a low P/E r a t i o i s j u s t i f i e d i n a n t i c i p a t i o n of a poor f u t u r e earnings t r e n d . - High P/E r a t i o stocks o f t e n r e p r e s e n t p r i c e s which i n -v e s t o r s b i d too s h a r p l y i n r e l a t i o n t o a c t u a l growth. The Investment D e c i s i o n Making Process Most T r u s t Companies have t h e i r own Research Depart-ments though some favour o u t s i d e r e s e a r c h work pro-v i d e d by brokerage houses and independent r e s e a r c h f i r m s . Fundamental a n a l y s i s accounts f o r a t l e a s t 80% o f the o v e r a l l investment d e c i s i o n s . Fundamental a n a l y s i s normally proceeds from the g e n e r a l to the s p e c i f i c . - 8 -- A l l analysts place a great deal of emphasis on the P/ER but are not generally i n agreement on the in t e r p r e t -ation of the P/ER. A high P/ER i s not generally considered to be desirable. When considering the P/ER the analyst w i l l study i t i n r e l a t i o n to the popular indices, to other companies i n the indus-t r y and also i n r e l a t i o n to the companies projected growth rates. Generally analysts prefer a stock with a low P/ER which most f e e l i s an ind i c a t i o n of an underpriced stock. Some analysts use the Relative Value Technique to vary-ing degrees. - Such models such as those of Markowitz are not used nor even understood. The information and advice offered by brokerage houses and investment counselling firms i s widely used. RECOMMENDATIONS An investment manager must have a clear understanding of the type of pension plan he i s to administer before he attempts to e s t a b l i s h an investment strategy. - The role of investment y i e l d must be determined and understood as i t concerns costs and benefits of a pension plan. Earnings per share of each security must be brought to a common base before any consideration may be given to - 9 -such investment tools as the Price Earnings Ratio. Investment managers should focus on assumptions behind the value of each P/ER when considering corporate growth. Sustained Corporate Growth i s dependent on s i x variables: Margin Turnover Leverage Tax Rates External factors a f f e c t i n g book value Retention Rate, a l l of which must :be considered before investment decisions are f i n a l i z e d . Analysts should not consider a high P/ER as an i n -dication of future growth, i f they do they have chosen a poor indicator. Unless there i s strong evidence to the contrary a stock with a low P/ER should be purchased rather than stock with a high P/ER multiple i f the low P/ER stock meets these conditions: a consistently high earnings record i n past years. - There i s no evidence of an earnings decline i n future years. The quality of management i s high. There i s a r e l a t i v e l y high margin and turnover. - 10 -CONTRIBUTIONS It must be appreciated that many Investment Managers and Pension Department Heads are reluctant to o f f e r c o n f i d e n t i a l information i n a highly competitive industry. Therefore, i t i s d i f f i c u l t indeed to assimilate information for a thesis such as t h i s . Some firms were extremely co-operative while others merely ignored requests for information. Those firms who offered t h e i r co-operation i n t h i s study were: Canada Trust Company Yorkshire Trust Company P h i l l i p s Hager and North Ltd. J.B. McFarlane Investment Counsellor (formerly of Royal Trust) Lapage & Verseveldt Ltd. (formerly of Royal Trust) The following firms were asked to make submissions i n which the questionnaire was camouflaged: Canada Permanent Trust Co. Montreal Trust Co. National Trust Co. Royal Trust Co. As a r e s u l t , t h i s Thesis contains information generally considered to be highly c o n f i d e n t i a l throughout the Industry. - 11 -With t h i s i n mind, I would l i k e to o f fer my s incere thanks to those firms and ind iv idua l s who so w i l l i n g l y offered t h e i r ass i s tance. CHAPTER II PENSIONS FUNDS IN CANADA In Canada, registered pensions f a l l into two broad methods of funding: a) The Insured* method and b) The Trusteed method. Under (a) the pension i s set up with an insurance com-pany much the same as endowment plan where the firm enters into an insurance contract and therefore i s not concerned with the investment performance since the contract stipulates how much the firm pays each year and how much the employees w i l l receive i n benefits. The contributions become the property of the i n -surance company. Insurance companies often o f f e r , under pressure, two variations from the endowment type plan. They are: a) Segmented funds which allows some element of control of the pension assets. b) Deposit Administration plans where a contract i s entered into but the assets remain the property of fund per se. Under the Trusteed method the assets remain the property of the fund, held i n tr u s t for the b e n e f i c i a r i e s . The funds may be managed by the Trustee or a management committee. Further, - 13 -the a s s e t s may be t r a n s f e r r e d from one Tru s t e e t o another on the d e c i s i o n o f the Pension T r u s t e e s . Since the g r e a t e r percentage o f pension a s s e t s are funded under the T r u s t e e d method where performance becomes i n c r e a s i n g l y important, t h i s t h e s i s w i l l d e a l w i t h the e f f e c t o f the P r i c e / Earnings r a t i o i n investment d e c i s i o n s i n T r u s t e e d Pension p l a n s . In g e n e r a l , pension plans i n Canada can most e a s i l y be d i s t i n g u i s h e d by determining the amount o f the pension. In t h i s way two broad c l a s s i f i c a t i o n s emerge, namely: (A) Where the Cost i s Known, but the F i n a l B e n e f i t i s Unknown, (B) Where the F i n a l B e n e f i t i s Known, but the Cost i s Unknown. (A) Where the Cost i s Known Under the f i r s t category the r e f e r e n c e s p e c i f i c a l l y i s to the MONEY PURCHASE PLAN or i t s v a r i a t i o n the P r o f i t Sharing Pension P l a n . In a Money Purchase P l a n , the pension i s determined by whatever can be p r o v i d e d a f t e r a s t a t e d r a t e of c o n t r i b u t i o n and the ensuing accumulation by way of compound i n t e r e s t . The amount of pension, t h e r e f o r e , i s whatever the accumulation w i l l buy. The main advantages o f the Money Purchase P l a n are as f o l l o w s : (1) The c o s t i s c o n t r o l l e d i n r e l a t i o n s h i p t o the employer's p a y r o l l . For example, i t may be f i x e d at 10% o f p a y r o l l . (2) The Money Purchase Plan i s non-actuarial, that i s , a c t u a r i a l calculations are not required since the ultimate benefit i s unknown. '(3) The plan does not discriminate between sex and age (4) It i s very simple and uncomplicated, easy to administer and r e a d i l y understood. The main disadvantages are: (1) The ultimate pension benefit i s too c l o s e l y related to earnings. For example, i f an employee receives a substantial salary increase i n the l a s t f i v e years of a 35-year span of employment, there i s not s u f f i c i e n t time to b u i l d up a benefit which i s adequate i n r e l a t i o n to his f i n a l salary. Also, from the employee's point of view, the plan i s disadvantageous because he cannot predict what his f i n a l pension w i l l be. (2) The introduction of a Money Purchase Plan can discourage the employment of the older employee. For example, i f the contribution i s constant for a l l ages and the employee i s i n an older age bracket, his accumulated amount w i l l be less than that for a younger employee. This can be counteracted, however, by applying d i f f e r e n t rates of contribution to d i f f e r e n t age brackets, which, of course, increases the employer's cost for older workers. - 15 -(3) It cannot be expected to r e a l l y solve the pension problem. (B) Where the F i n a l Benefit i s Known The second broad c l a s s i f i c a t i o n of Pension Plan covers DEFINITE BENEFIT PLANS. This p a r t i c u l a r group can be broken down into two types of:plan, namely, the F l a t Benefit and the Unit Benefit. (1) F l a t Benefit Plan This plan i s , by d e f i n i t i o n , not wage related. The amount of pension depends so l e l y on years of service, paying a certain number of d o l l a r s per year m u l t i p l i e d by the number of years of service. For example, the pension benefit may be $2.00 per month of pension for each year of service, so that an employee with 40 years of service would receive a pension of $80 per month. Another v a r i a t i o n of this plan i s the Fixed Pension for employees with a minimum service requirement. For example, $60 per month af t e r ten years of service. Because i t ignores salary, t h i s type of plan i s e a s i l y bargained for and herein l i e s i t s main advantage. There are, however, several disadvantages: (1) the cost cannot be determined i n advance without a c t u a r i a l assessment, (2) since t h i s plan does not take into consideration wages and i n f l a t i o n , the formula must be fi x e d at each bargaining session, - 16 -(3) the plan does not consider wage d i f f e r e n t i a l s , (4) benefits tend to be rather low i n relationship to other types of plans. (2) The Unit Benefit Plan There are four main classes of Unit Benefit Plans which are popular at t h i s time: (a) The Career Average Earnings Plan - Generally speaking, t h i s i s a 2% benefit. For example, an employee working for a company for three years would emerge with a pension determined as f o l -lows: for year one on earnings of $400 per month a unit of pension of $8 per month. For the next year on an earnings of $450 per month, the t o t a l benefit being $17 per month. From the employee's point of view, t h i s plan i s most l i k e l y to produce a more s a t i s f a c t o r y pension than a f l a t benefit plan simply because i t i s wage and service related. I f , however, a re-t i r i n g employee i s an executive who has 4 0 years of service, 30 of which were at a r e l a t i v e l y low salary, then the f i n a l pension that he receives may not be adequate from his point of view. This thinking leads us to the second type of Unit Benefit Plan, which i s -- 17 -(b) The F i n a l Earnings P l a n - T h i s type o f p l a n i n -v o l v e s a percentage o f the employee's earnings i n h i s f i n a l year o f s e r v i c e m u l t i p l i e d by h i s t o t a l number o f years s e r v i c e . In most cases t h i s b e n e f i t i s 1 1/2% so t h a t f o r an employee who earned $1,000 per month i n h i s l a s t year o f s e r v i c e and who had worked f o r 30 y e a r s , a pen-s i o n o f $450 per month would emerge. A favour-able f a c t o r i s t h a t the p l a n g i v e s a more d i r e c t r e l a t i o n s h i p t o the employee's most r e c e n t s t a n -dard o f l i v i n g . One cannot, however, always assume t h a t the l a s t year o f employment w i l l be the one with the h i g h e s t wage. For a v a r i e t y of reasons an employee's earnings may be d r a s t i c a l l y reduced d u r i n g the l a s t year o f employment. Be-cause o f t h i s , another v a r i a t i o n o f the U n i t B e n e f i t P l a n was developed and i t i s r e f e r r e d t o as the -(c) Average F i n a l Earnings P l a n - Th i s i s merely a v a r i a t i o n o f the F i n a l Earnings P l a n whereby the l a s t f i v e or ten years average earnings are used i n s t e a d o f j u s t the l a s t year's e a r n i n g s . T h i s p l a n serves t o de-emphasize the p o s s i b i l i t y o f one bad year b e f o r e r e t i r e m e n t , but i t does not h e l p a d e c l i n i n g wage p a t t e r n . T h i s leads - 18 -us then to the fourth v a r i a t i o n , or -(d) The Average Best Earnings Plan - Here a percen-tage of the average best years over a designated period of time i s used i n determining the benefit. It i s more sa t i s f a c t o r y from the point of view of an employee for obvious reasons. This i s the plan used by the Federal C i v i l Service and by the Canadian Armed Forces. The variations on the unit benefit theme are almost l i m i t l e s s and are dependent only on one's a b i l i t y to discover new twists. For example, a plan can be weighted for age of entry and length of service and i s commonly referred to as a "tapered" plan. For example, the pension benefit may be 1% for service up to age 30; 1 1/2% from 31 to 40; 2% from 41 to 50; 2 1/2% from 51 to 64. Assuming age 28 on entry, the f i n a l pension at 65 would be -2 x 1 % 10 x 1 1/2% 10 x 2% 15 x 2 1/2% - or making a t o t a l of 77% on" his f i n a l earnings. There are of course certain advantages and disadvan-tages to the Unit Benefit type of plan. One of the main ad-vantages i s that the plan i s service and wage related. In th i s manner, pensions can be related to the average career or f i n a l standard of l i v i n g . In addition, because i t i s t i e d to - 19 -earnings, the pension tends to i n f l a t e with the cost of l i v i n g . One f i n a l and very re a l advantage i s that pension benefits are r e l a t i v e l y simple to calculate. At any given time during his employment, the employee can pretty well t e l l what his f i n a l pension w i l l be. On the other hand, the Unit Benefit plan i n -volves additional cost due to the need for continuous a c t u a r i a l supervision since the f i n a l cost to the employer cannot be de-termined i n advance. For example, he does not know what kind of increase i n the l e v e l of earnings paid there w i l l be over the next 30 to 40 years. The eventual cost under such circum-stances can be reduced, however, by setting a l i m i t on the top pension payable. For example, the plan may c a l l for a pension of no greater than $1,000 per month. It i s i n t e r e s t i n g to note how the various types of plans mentioned are u t i l i z e d by em-ployers. By f a r the most popular plan i s the Money Purchase Plan which accounts for 60% of the plans, but covers only 13% of the membership of a l l plans. The F l a t Benefit Plan accounts for approximately 5% of a l l plans and covers 10% of the member-ship i n a l l plans. Unit Benefit Plans account for 31% of a l l plans i n use and cover. 75% of the membership. The remainder, namely 4% of a l l plans, covering 2% of membership are Compo-s i t e Plans. The Composite Plan i s merely one which combines a Money Purchase and a Unit Benefit Plan-. For example, the em-ployer purchases a pension of the Unit Benefit type and the em-ployee contributes a cert a i n stipulated percentage of his earn-ings which purchases an additional pension of the Money Pur-- 20 -chase type. Pension Plans are l i k e shoes - they must be f i t t e d to the wearer's needs. This i s done through a pension con-sultant. - 21 -CHAPTER III THE IMPORTANCE OF INVESTMENT YIELD In Chapter II we described the various types of pension plans and benefits to the employee. It now becomes important to understand the COST of a pension plan. The cost i s incurred by both the employer and the employee. Often the employee's cost i s i n d i r e c t i f i t i s a non-contributory plan, in which case his cost i s a function of the benefits received or foregone, depending on the y i e l d generated by the fund. Many people have a mistaken idea that the "cost" as i t relates to a pension plan i s the money deposited i n any given period. This remittance i s , however, only a deposit against the cost. The r e a l "cost" of a pension plan to an employer and to the employee can be stated very simply as: (1) The t o t a l of a l l benefits paid out plus (2) The administrative expenses minus; (3 ) The amount of employees contributions minus (4) The earnings of the fund. It should be noted from the preceding equation that the only two variables'*" are "expense" and "earnings of the fund". Of these two variables, "the earnings of the fund" or invest-- 22 -merit y i e l d , has i n f i n i t e l y greater e f f e c t i n reducing the costs of employee benefits. D i f f e r e n t i a l s i n investment y i e l d produce s t a r t l i n g variations i n the r a p i d i t y with which pension funds grow. The Figure 3.1 w i l l i l l u s t r a t e " t h i s point. Here i t has been as-sumed that regular net annual contributions of $1,000.00 w i l l be made over periods of 10, 20 and 30 years, with accumu-l a t i o n at rates running from 0% to 8% per year. It i s also assumed that the actuary has based the plan contributions on the fund earning 4% per annum. From Figure 3.1 i t becomes read i l y evident that i n -vestment y i e l d i s a most powerful force i n determining not only what the r e a l cost of the penaion plan w i l l be but also the benefits. In general terms an improvement of 1/2 of 1% per annum in investment y i e l d may r e s u l t i n a cash saving of lOto 15% or increased benefits i n the 8 to 12% range. These differences, i n turn can produce s i g n i f i c a n t variations i n corporate p r o f i t s . Therefore, with these possible variations i n results and the large sums of money involved, corporate f i n a n c i a l o f f i c e r s have a r e a l r e s p o n s i b i l i t y to: a) Know what the actual y i e l d of these company funds are and b) Know how they compare with the y i e l d s of other LIKE funds. - 2 3 -Because of the importance of investment y i e l d to the "corporate f i n a n c i a l o f f i c e r s and since the actuary usually recommends not only the method of funding the plan but also the investment manager, a new "performance c u l t " has developed among investment managers, actuaries and f i n a n c i a l o f f i c e r s of the firms contributing. Today even union members are passing comments on the performance of t h e i r pension funds, l i t t l e r e a l i z i n g that every time they s t r i k e or demand excessive wages they are reducing the value of the assets i n that fund. The public f a i l s to r e a l i z e that regardless of the contract, a firm can only pay pension benefits out of the assets they hold. Even a f u l l y funded pension plan that can meet i t s l i a b i l i t i e s today may not be able to a few weeks from now i f there i s a severe market decline p a r t i c u l a r l y i f union demands send some of the firms into bankruptcy. Be that as i t may, today's attitude i s that the greatest portion of the fund's assets should not only be placed i n equities but also they should have a high growth po t e n t i a l since growth can often produce the greatest portion of investment y i e l d . Let us assume that a pension fund has an i n f i n i t e time horizon, r e l a t i v e to other investors, also that over that i n f i n i t e time span old established corporations die or are replaced. Packard, Studebaker, Piggly-Wigglys are some and possibly even Penn Central and Chrysler Motors may succumb. Pension funds are often major shareholders i n such firms. Over th i s time horizon,is the greatest y i e l d to be derived from dividend payout or by stock appreciation? Appreciation only becomes tangible i f and when the stocks are sold. Some of those mentioned above have become worthless even though they may have been glamour stocks at one time. The performance c u l t believes that appreciation i s the most important part of equity investment and that "timing" i s the c r u c i a l thing i n performance. That i s "Buy Low S e l l High" - "BLSH". Their attitude i s often that the stock i s s e l -l i n g at a high multiple, overpriced, but since the stock i s on the r i s e , the investment manager decides to purchase on the "bigger f o o l than me" p r i n c i p l e . The c r u c i a l decision i s when to s e l l i n following t h i s philosophy. Otherwise the manager in question becomes the bigger f o o l . The problem of timing i n a pension fund i s one of not only "when" to s e l l , but also a more d i f f i c u l t one "how" to s e l l . Pension funds usually hold large blocks of stocks, and when the word i s out that an i n s t i t u t i o n a l investor i s s e l l i n g a large block of these glamour stocks, the stocks often drop d r a s t i c a l l y , even though the general market trend may be up-ward. This then i s the problem of timing, but consider now how a m u l t i - m i l l i o n d o l l a r fund might try to s e l l Chrysler Motors without seriously depressing the stock or even the firm. After a l l , the t r u s t company managing the pension fund might even be the stock r e g i s t r a r and dividend dispersing agent for that firm they a<Ee s e l l i n g out. What of the investment manager who opts out of the performance c u l t and i s more interested i n dividend payout and modest growth, than appreciation? Alas! His performance i s usually l i t t l e better than the "popular averages" and i n the short run he i s often outperformed. Few actuaries w i l l recom-mend him for new pension trusts and as mentioned above, the corporate f i n a n c i a l o f f i c e r s w i l l constantly compare his per-formance to that of l i k e funds and may transfer t h e i r assets to the fund showing the "best" performance for that "year". The r e s u l t of the performance race was that investment managers began to purchase more growth stocks from about 1965 onward, and since performance was measured by appreciation p r i -marily the purchase of high multiple stocks snowballed. By 1968 a l l sorts of accounting and reporting gimmicks were introduced, to make t h e i r funds look good, p a r t i c u l a r l y the reporting date for funds. I f , by dating your report one week previously you could show better performance, th i s was done. A multitude of methods were developed to judge performance and of course the fund would choose the method that best suited i t s own purpose. But overshadowing a l l t h i s , was the constant search for better than average growth and a gradual purchase of more speculative investments not to f u l f i l l the purpose of the pension funds, but to show performance, emerged. Then i t came i n 1969 and continued through to May, 1970, and again i n November, 1971. The bottom f e l l out of the stock market and most investment managers f e l t themselves f o r -tunate i f . t h e i r p o r t f o l i o of equities f e l l by less than 30%. . At tfris time fixed income s e c u r i t i e s were o f f e r i n g y i e l d s of - 26 -over 10% much higher than earnings c a l l e d for by any pension plan. The r e s u l t was that many pension funds were grossly under-funded and corporations had to use funds from working c a p i t a l to meet the requirements of the plan, a l l during a serious recession reminding the f i n a n c i a l manager of the vices of avarice and greed. , A more serious problem was the one of meeting the funds l i a b i l i t i e s when employees r e t i r e . In order to purchase an annuity for a r e t i r i n g employee, up to 150% more equities had to be disposed of to meet the cost of the annuity; since most trusteed funds purchase annuities for r e t i r i n g employees. , An even more serious problem arose for the employee r e t i r i n g i n 19 70 on a Money Purchase Plan or a Registered Retirement Savings Plan, whose pension was based on what the money contributed would buy. In 1968 i t could have bought him a 30% larger annuity than i t did i n 1970. Here i t gives us cause to wonder i f the "prudent man rule" had been observed. Since 1970 investment managers and actuaries are now wondering whether i t i s wise or even prudent, to chase aft e r the glamour stocks with the high Price to Earnings Ratio, p a r t i c u l a r l y when t h e i r investment philosophy could have such far reaching e f f e c t s on the pensions of those about to r e t i r e . Footnote. No. 1, Page 21 Other costs are fixed throughout the relevant range. CHAPTER IV DETERMINING EARNINGS PER SHARE The purpose of this chapter i s two-fold: A. To focus attention to cer t a i n procedures now being employed when determining earnings per share. B. To make the reader aware of some of the short-comings of the use of such data as an input to i n -vestment selection techniques. BACKGROUND 1 In the past the method of computing EPS was to divide the amount shown as net income (minus preferred stock dividends) by the weighted average of the number of common shares outstanding during the accounting period being reported upon. Four methods for determining per share earnings figures were deemed acceptable. These were: Income before extraordinary items per share of common stock or other residual s e c u r i t i e s outstanding. - Income afte r extraordinary items per share of common stock or other residual s e c u r i t i e s . - Pro forma per share income before extraordinary items r e f l e c t i n g p o t e n t i a l d i l u t i o n . - Pro forma per share income a f t e r extraordinary items r e f l e c t i n g p o t e n t i a l d i l u t i o n . EXHIBIT 4.1 PRESENTATION OF PER SHARE DATA PER SHARE OF COMMON STOCK 1967 1966 Income Before Extraordinary items $1.73 $1.37 Extraordinary items, net of tax (34) (22) Net Income $1.39 $1.15 Pro forma per share of common stock/ r e f l e c t i n g conversion (NOTE A) Income before extraordinary items $1.53 $1.21 Extraordinary items net of tax (31) (19) Net Income $1.22 $1.02 Note A. The pro forma per share data are based on the assump-tio n that 5 1/2% convertible debentures outstanding at December 31, 1967 were converted into common shares at the conversiohoEate i n e f f e c t that date, r e f l e c t i n g the 800,000 shares issuable on conversion and eliminating the related i n t e r e s t on the conver-t i b l e debentures (less applicable income tax) of $50,000. EPS for^corporations with complex c a p i t a l structures are: F i r s t : Residual s e c u r i t i e s other than common stock may 2 enter into the computation of EPS. Residual s e c u r i t i e s may be defined as follows: - 29 -When more than one class of common stock i s outstand-ing, or when an outstanding security c l e a r l y derives a major portion of i t s value from i t s conversion rights or i t s common stock c h a r a c t e r i s t i c s , such s e c u r i t i e s should be considered "residual s e c u r i t i e s " and not "senior s e c u r i t i e s " for the purpose of com-puting EPS. Second: Pro forma EPS data r e f l e c t i n g potential d i l u t i o n must also be furnished i i i annual reports to stock-3 holders. Under certain circumstances, EPS may be subject to d i l u t i o n i n the future i f ex i s t i n g contingencies per-mitting issuance of common shares eventuate. Such circumstances include contingent changes r e s u l t i n g from the existence of: outstanding senior stock or debt which i s con-v e r t i b l e into common shares. - outstanding stock options, warrants or si m i l a r agreements. - agreements for the issuance of common shares for l i t t l e or no consideration upon the s a t i s -faction of certa i n conditions. If such p o t e n t i a l d i l u t i o n i s material, supplementary computations of EPS should be furnished, showing what the earn-ings would be i f the conversions or contingent issuances took place. - 30 -More recently accountants have recognized that the residual security concept described above raises many questions i n i t s application, and have concluded that modifications and more detailed statements were desirable. Here i t may be worthwhile to review the terminology used: EXHIBIT 4.2 Residual security - common stock equivalent Primary EPS - Income afte r extraordinary items per share of common stock or other residual security outstanding. F u l l y d i l u t e d EPS - Pro forma per share income afte r extraordinary items r e f l e c t i n g p o t e n t i a l d i l u t i o n . DETERMINATION OF PRIMARY EPS The most recent method of determining Primary EPS i s based on outstanding common shares and only those common stock equivalents that have a d i l u t i v e e f f e c t of 3% or more. There-fore, i t i s important to note that a common stock equivalent may or may not be r e f l e c t e d i n the determination of primary EPS. Hence, to be included i t must have the e f f e c t of reducing EPS. Common Stock Equivalent To determine common stock equivalent status, i t i s necessary to d i f f e r e n t i a t e between -- Options and warrants - 31 -- Convertible s e c u r i t i e s . Options and warrants should always be regarded as 4 common stock equivalents. Convertible debt or convertible preferred stock should be considered as a common stock equivalent at the time of issue, i f , based on i t s market price, i t has a cash y i e l d of 5 less than 2/3 of the current bank prime inter e s t rate. The tests of common stock equivalent status of prime importance to anyone using amounts reported as primary EPS are: F i r s t , t h i s test i s made at the time of o r i g i n a l issuance of the security i n question and once a security's status i s determined, the status never changes. Consider Exhibit 4.3 For Company B the convertible debt i s not considered as a common stock equivalent, because i t s cash y i e l d (3%) exceeded 2/3 of the current (1959) bank prime in t e r e s t rate (4%). However, for Company A the convertible debt i s considered as a common stock equivalent. Yet i t i s Company B's debt holders who should convert at present market prices i n the event of approaching maturity or of a c a l l i n g on the bonds. However, the general b e l i e f that the presentation of f u l l y d i l u t e d EPS data adequately discloses the poten t i a l d i l u t i o n which may exis t because of changes i n conditions subsequent to time of issuance i s i n error for at least two 6 reasons: I t does not allow for comparability of EPS between companies that d i f f e r i n the o r i g i n a l and maturity issuance dates of t h e i r respective convertible s e c u r i t i e s . -It seems inconsistent that the less l i k e l y "potential" d i l u t i o n i s to be r e f l e c t e d i n the primary EPS, while the more l i k e l y case of d i l u t i o n i s r e f l e c t e d only i n f u l l y d i l u t e d EPS. The second te s t of common stock equivalent status i n general use i s that i t represents a change from the c r i t e r i a used p r i o r to 1969. Therefore, i t i s to be expected that re-ports prepared aft e r 1969 for some companies w i l l vary i n the number of shares, hence the primary EPS they show compared to previous years. This w i l l r e s u l t i n the r e c l a s s i f i c a t i o n of certain convertible issues; otherwise there may be serious inconsistencies between companies as regards common stock equivalents. This means that analysts w i l l need to check the basis for any previously determined Earnings Per Share re s u l t s or estimates reported p r i o r to the most recent changes i n ac-counting procedures p r i o r to 1969. Now consider the determination of primary EPS where there are warrants outstanding. As previously stated, options and warrants are always regarded as common stock equivalents and therefore entered into the computation of primary EPS, i f and only i f , t h e i r i n c l u s i o n has the e f f e c t of decreasing the per share amount of earnings. Under t h i s method EPS data are - 33 -computed as i f the options and warrants were exercised at the beginning of the period (or at time of issuance, i f l a t e r ) , and as i f the funds obtained by the issuance were used to pur-7 chase common stock at the average price during the period. This method i s normally limited to 20% of the common shares outstanding. This method i s i l l u s t r a t e d i n Exhibit 4.4. H i s t o r i c a l common share market prices are not relevant to the determination of primary EPS since: (1) H i s t o r i c a l prices r e f l e c t previously held expect-ations which do not necessarily bear any relat i o n s h i p to current expectations. (2) The amount reported as primary EPS i s intended to re-f l e c t , on a pro forma basis, that potential d i l u t i o n currently e x i s t i n g . From EXHIBIT 4.4 i s can be noted that Companies X and Y w i l l report d i f f e r e n t amounts as primary EPS even though a l l obvious f i n a n c i a l considerations are i d e n t i c a l for the two companies. This i s the r e s u l t of the procedure of basing the d i l u t i o n computation on h i s t o r i c a l common stock market prices which may or may not approximate market prices at the time the analyst receives his annual report and may not r e f l e c t the d i l u t i o n e f f e c t e x i s t i n g at that time. Therefore, before using reported primary EPS figures, the analyst should deter-mine the e f f e c t r e s u l t i n g from changes i n market prices . In th i s example, using market prices of 1 March 1970, a recom-- 34 -putation of primary EPS y i e l d s $3.72 ($4,000,000/1,075,000) for each company. The procedure of basing per share computations on the weighted average of the number of common shares a c t u a l l y out-standing during the period being reported i s l o g i c a l , since the resources received when additional shares issued during that period, are available for use for a corresponding portion of the period. Therefore, i f the firm continued to earn the same rate of return on shareholders equity, the past periods earnings per share would equal the following periods EPS ex-cept for increase due to the previous retained earnings. There i s no corresponding l o g i c a l explanation for the procedure of using a weighted average of the net number of shares that would have been added i f warrants had been conver-ted, since no additional assets (Net Assets) would have been received. Also, i t must be remembered that these are only pro forms or "what i f " computations. Therefore, i t seems l o g i c a l to base such computations on the t o t a l net increase i n the number of shares outstanding that would r e s u l t i f conversion were to take place at current market prices . This was the method used i n recomputing the primary EPS figure of $3.72. In the past EPS figures covering a number of periods have often been used i n assessing a firm's earning power and i n forming investment decisions based on i t s p o t e n t i a l . More recently procedures have introduced a new determinant of primary EPS which w i l l , (for companies with warrants out-standing) reduce t h e i r appropriateness f o r t h i s use, since - 35 -changes i n the l e v e l of a firm's common stock price w i l l now d i r e c t l y a f f e c t the l e v e l of i t s reported primary EPS. Once the market price of the firm's common r i s e s above the exercise price of any warrants outstanding, a s t i l l higher price w i l l r e s u l t i n a lower price for the common w i l l increase primary EPS. DETERMINATION OF FULLY DILUTED EPS The recent policy of requiring the presentation of f u l l y d i l u t e d EPS was to show the maximum poten t i a l d i l u t i o n g of current earnings per share on a prospective basis. Hence a l l contingent issuances of addit i o n a l shares would be r e f l e c t e d i f the r e a l i z a t i o n of such contingency would have the e f f e c t of reducing EPS. However, t h i s does not seem to apply with respect to outstanding options and warrants even though i t i s true with respect to convertible s e c u r i t i e s . With respect to options and warrants, f u l l y d i l u t e d EPS are calculated by means of the treasury stock method, except that the market price at the close of the reporting period i s used in determining the number of shares assumed to have been repurchased i f such market price i s higher than the average price used i n computing primary EPS. Therefore, i f the exercise price exceeds both the period average and period end market pr i c e s , warrants and/or options outstanding w i l l have no e f f e c t i n the determination of reported f u l l y d i luted EPS. On the other hand, a l l non common stock equivalent - 36 -convertible debt i s used i n determining f u l l y d i l u t e d EPS, as i l l u s t r a t e d i n EXHIBIT 4.3. In summary, from the viewpoint of a pot e n t i a l investor there are two undesirable aspects to f u l l y d i l u t e d EPS figures as reported: A. The complete omission of the poten t i a l d i l u t i o n e f f e c t due to warrants and/or options whose exercise prices are i n excess of market prices pre-v a i l i n g during the reporting period. B. The lack of any indicati o n of the extent of remote-ness associated with those d i l u t i o n e f f e cts that are r e f l e c t e d i n f u l l y d i l u t e d EPS. In order to overcome these undesirable aspects of the f u l l y d i l u t e d EPS figures as reported, an alternative pro-cedure suggested by J.E. Parker i s presented i n EXHIBIT 4.5. Under t h i s a l t e r n a t i v e , the analyst would develop not one but a schedule of d i l u t e d EPS amounts where each amount i s as-sociated with a given pot e n t i a l future market price of common stock. By employing t h i s r e l a t i o n s h i p between the commons market price and the l i k e l i h o o d of actual conversion or exercise, the analyst w i l l be able to determine the portion of the firm's current income that i s l i k e l y to be attributable to a single share i n the event of each of several d i f f e r e n t future occurrences. This i s the procedure recommended by th i s writer. CHAPTER IV INDEX TO FOOTNOTES *James E. Parker, CP.A. , New Rules for  Determining Earnings per Share, F i n a n c i a l Analysts Journal, January - February, 1970. Accounting P r i n c i p l e s Board, Opinion No. 9, p. 120, American Inst i t u t e of C e r t i f i e d Public Accountants, December 1966, p. 139. Ibid., p. 123. Accounting P r i n c i p l e s Board "Earnings per Share", Opinion No. 15, A.I. of CP.A. , December 1966, p. 230. Ibid., P- 229. Ibid., P- 227. Ibid., P. 320. Ibid., P- 234. For additional information on Earnings per Share see: C.I.C.A. Handbook Section 3500 - Earnings per Share Pages 2051 to 2079. Exhibit 4.5 Notes 1 and 2. Note 1. Conversion Value read ($40. x 20,000) Note 2. Conversion Value read ($50. x 20,000) *James E. Parker, Ph.D., CP.A., Professor of Accounting at the University of Missouri. EXHIBIT 4«3 Hypothetical Examples of Primary EPS Determination' Where Convertible Debt Is Outstanding Company A Company B $ 4,000,000 S 4,000,000 1.000,000 1,000,000 Market price of common — 1969 $35 $40 $15 515 Data re convertible debt S10,000,000 $10,000,000 3 % 3 % Conversion price per common share S50 $20 Original data of issuance 1/1/69 1/1/59 Assumed bank prime interest rate at 6% 4% S100 $100 •Primary earnings per share — 1 9 6 9 $3.46 $4.00 "Computation of primary earnings per share for Company A: 5 4,000,000 Interest on debt (3% of S10,000,000) S 300,000 150,000 150,000 Adjusted income $ 4,150,000 Common shares outstanding 1,000,000 Common stock equivalent ($10,000,000 -t- S50) 200,000 1,200,000 Primary earnings per share ($4,150,000 -r 1,200,000) $3.46 EXHIBIT 4»4 Hypothetical Examples of Primary EPS Determination Whe_re Warrants Arc Oustanding Company X Company Y 5 4,000,000 5 4,000,000 1,000,000 1,000,000 Warrants outstanding 200,000 200,000 $50 $50 Market price of common Average — 1st quarter 1969 $40 $100 $40 $80 ' Average — 3rd quarter 1969 $70 $120 $60 $100 As of 3/1/70 $80 $80 Average — 3rd and 4th quarters 1969 . $65 Average — yeaT 1969 $100 Adjustment of shares outstanding: 200,000 200,000 * Proceeds (200,000 X 550) S10,000,000 $10,000,000 Reacquired: ($10,000,000 -5- S65) 153,846 ($10,000,000 + S100) 100,000 46.154 100,000 Portion of year outstanding ^ 50% 100% 23,077 100,000 1,000,000 1,000,000 Adjusted shares outstanding 1,023,077 1,100,000 Primary earnings per share ($4,000,000 + 1,023,077) $3.91 ($4,000,000 1,100,000) $3.64 EXHIBIT 4.5 DATA Net income for 1%9 $4,000,000 Common shares outstanding 1,000,000 Market price of common during 1969 . . . . S35-S45 Assumed bank prime interest rate — 1969 6% Convertible 5% Bonds — due 1980 $1,CC0,000 Conversion price 550 12/31/69 market price $100 Date issued 1960 • Convertible 6% Bonds—due 1985 $1,000,000 Conversion price 550 12/31/69 market price $120 Dale issued ' 1965 A Warrants —expire 1990 100,000 Exercise price $55 Date issued 1964 B Warrants — expire 1995 100,000 Exercise price 570 Date issued 1967 PROCEDURE UNDER OPINION 15 Net income for 1969 : Interest on 5% Bonds 5 50,000 Interest on 6% Bonds 60,000 $ 110,000 Tax savings •. 55,000 Adjusted net income » . . . . Actual common shares outstanding Issuable on conversion of 5V» 8onds Issuable on conversion of 6% Bonds Adjusted ..umber of common shares Fully-diluted EPS ($4,055,0004-1,040,000) ' $4,000,000 $ 55,000 $4.055,000 1,000,000 20,000 20,000 1.040.C0Q „$3.90 PROCEDURE UNDER WRITER'S SUGGESTED ALTERNATIVE SCHEDULE OF DILUTED EPS Market Price of Common $40 $50 £60 $70 $so EPS $4.00 S3.95 $3.87 53.82 $3.74 CALCULATIONS Market Price of Common Adjustments $40 $50 560 $70 $80 None (Mote 1) Conversion of 5% Bonds (Note 2) Conversion of 6% Bonds and Exercise of A Warrants (Note 3) Reversal Exercise of A Warrants (Note 4) Reversal Exercise of A V/arrants and Exercise of B Warrants (Note 5) Shares Income EPS 1,000,000 S4.O00.CCO 54.C0 20.CC0 $ 25,000 1,020,000 S4.025.000 S3.9S 20.000 $ 30,000 8,333 1.048,033 $4,055,000 $337 (8,333) 21,429 1.061,429 $4,055,000 $3.02 (21,429) 31,250 12.500 1.083,750 $4,055,000 S3.74 Note 1 ($40 market price) 5% Bonds 6% Bonds Conversion value ($40 X 200,000) $ 800,000 $ 800,000 Estimated premium 200,000 400,000 Estimated market value $1,000,000 $1,200,000 Cash interest $ 50,000 $ 60,000 Cash yield 5V. 5% Current bank prime rate 6% 6% No adjustment is required since th; cash yield for each bond is greater than 75% of the prime bank rate. (Note: this means of deciding whether lo assume conversion is only one of several that could be employed. In this example the cash yield is related to 75% of the prime bank rale inslead of 66-2/3% Note 2 (S50 market price) 5% Bonds 6% Bonds Conversion value (S50 X 200,000) S1,C00,000 $1,000,000 Estimated premium 150,000 300^ 000 Estimated market value $1,150,000 SI 300,000 Cash interest $ 50,000 $ 60,000 Cash yield 4.35% 4.62% Current bank prime rate 6% 6% .Adjustment required for 5% bonds only Note 3 ($60 market price) 6% Bonds A Warrants Conversion value (S60 X 200,000) $1,200,000 Estimated premium 200,000 Estimated market value $1,400,000 Cash interest $ 60,000 Cash yield 4.29% Current bank prime rale 6% Adji.i>ifi>?ftl reouirH» for 6% Bond> Share's issued ...' 100,000 Proceeds (100,000 X $55) $5,500,000 Shares repurchased ($5,500,000 - $60) . . 91,667 Net increase in shares (100,000 - 91,667) 3,333 Note 4 (S70 market price) A Warrants Shares issued 100,000 Proceeds (100,000 X S55) $5,500,000 Shares repurchased ($5,500,000 * $70) .. 78,571 Net increase in shares (100,000 - 78,571) 21,429 Note 5 ($S0 market price) A Warrants B Warrants Shares issued 100,000 100,000 Proceeds (100,000 X $55) S5.500.000 (100,000 X $70). $7,000,000 Shares repurchased (S5.50O.000 - $80) 68.750 ($7,000,000 H--S30) 87,500 Net increase in shares (100.000 - 63.750) 31.250 (100,000 -s- E7.500) 12.500 CHAPTER V PRICE-EARNINGS RATIO AND ITS RELATIONSHIP TO CORPORATE GROWTH In order to understand the Price-Earnings Ratio of a security and i t s rel a t i o n s h i p to Corporate Growth, the invest-ment manager must have a clear understanding of the present value (Pv) formulae. The Pv i s merely the discount (1) of future returns (R) to a present value. Whether one wishes to c a p i t a l i z e dividends or earnings, the formulation has d i r e c t relevance to investment management and security analysis, as i t i s the d e f i n i t i o n of the value of a security ( i . e . , i t s stream of income). R, R_ Rn (1) Pv = 1 + z + (1 + k ) 1 (1 + k) 2 (1 + k) n Where (k) i s equal to the investors discount rate or oppor-tunity cost, (R) the value of future returns and (n) i s the number of years considered. The main objective of th i s chapter i s to present a l o g i c a l exposition of the factors to be weighed i n developing an appropriate valuation model for each stock considered and present the basic forces at work i n any present value f o r -mulation. The majority of analysts do not go through the actual - 38 -process of discounting forecasted earnings, (dividends), to a present value. However, they do go through the same process when they associate the fundamental or i n t r i n s i c value of a stock with the Price-Earnings Ratio. This chapter intends to accomplish two things: To develop the relationship between the present value formula and the Price-Earnings Ratio. To determine the significance of the Price-Earnings Ratio for investment decisions. THE PRICE-EARNINGS RATIO AND THE PRESENT VALUE FORMULAE The basic Pv formula i n (1) can e a s i l y be converted into an earnings c a p i t a l i z a t i o n model where the current price (P) i s equal to the summation of a l l future earnings (E) d i s -counted by (k), the investors discount rate or opportunity cost. Then: E E En 1 2 (2) P = 1 + A + ... (1 + k) 1 (1 + k) 2 (1 + k) n We may reduce the number of terms i n (2) by making three assumptions: - a constant growth rate, - an i n f i n i t e time horizon, - continuous compounding. A Constant Growth Rate Let us s t a r t with a known value for earnings. Here i t i s e s s e n t i a l that we use those earnings for the most recent f i s c a l year (E), and project a growth rate for subsequent periods (g). There w i l l be a v a r i a t i o n between forecasted earnings based on a constant growth rate and actual earnings. . This error should not be much greater than that derived by forecasting earnings for each year independently. Furthermore, the value of (g) represents an average growth rate over the investors time horizon, n years. (3) P = Eo (1 + g) ' + Eo (1 + g) 2 + _ (1 + k ) 3 (1 + k) 2 1 n Eo (1 + g) t Eo (1 + g) n (1 + k) n t t = 1 (1 + k) An I n f i n i t e Time Horizon This assumption i s based on two considerations: In most pension funds certain large blocks of se-c u r i t i e s are not traded since once they are sold they are d i f f i c u l t to accumulate. Further, i t i s assumed that the assets of large pension funds w i l l not be liquidated. The time horizon of pension funds i s assumed to be i n f i n i t e . Mathematical convenience. Rather than compounding and discounting earnings over a f i n i t e time horizon - 40 -- for n years which varies between 5 - 5 0 years de-pending on the investor. We compared over an i n -f i n i t e time horizon. oo (1 + g) t (4) P = > Eo t = 1 (1 + k) t The d i s t o r t i o n r e s u l t i n g i n terms of the stated value of a share of stock w i l l be very s l i g h t since the Pv of a d o l l a r 20 or 50 years from now diminishes so rapidly that the cumulative value of the earnings between the nth time period and i n f i n i t y w i l l constitute a very minor portion of the 2 current stock value. Continuous Compounding Rather than compounding and discounting d5or discrete time periods annually or quarterly as i n (4), earnings w i l l be compounded and discounted over i n f i n i t e l y small time periods. This results i n the formulation (5) which varies from (4) only i n that compounding i s on a continuous basis. oo , (5) P = Eo <S d g t e - cit Thus the current stock price i s equal to current earnings growing at rate g and discounted at rate k over i n -f i n i t e l y small time periods (dt), the variable i s the natural 3 log. When (5) i s integrated i t reduces to: (6) P = k - g To a r r i v e a t the concept of the p r i c e earnings r a t i o , d i v i d e both s i d e s by Eo: 1 (7) P/Eo = k - g O b v i o u s l y the formula i s meaningful o n l y when the value of the c a p i t a l i z a t i o n r a t e (k) i s g r e a t e r than the growth r a t e (g) or k^g; otherwise the P r i c e - E a r n i n g s Rate w i l l be i n f i n i t e o r n e g a t i v e . T h i s formula may be a p p l i e d t o glamour sto c k s s i n c e i t i s o n l y the long term growth r a t e which has r e l e v a n c e to the formula. So f a r the model has i m p l i e d t h a t a l l earnings have been passed on to the s h a r e h o l d e r . MODIFICATION OF THE MODEL Few investment managers are concerned about the 20 to 50 year growth of firms s i n c e only the near term r e t u r n s are important. Because the near term growth r a t e p l a y s such a major r o l e i n the d e t e r m i n a t i o n of investment v a l u e , we separate the P r i c e Earnings R a t i o i n t o two components: The d i s c r e t e summation of the most important near term growth (gs) The f i n i t e summation of the f u t u r e value of the s e c u r i t y beyond the near term (or nth y e a r ) . (g2) In t h i s manner the d e f i n i t i o n o f the P r i c e Earnings R a t i o may - 42 -be conceptually correct and relevant for situations where a l l earnings are passed on to the stockholder. I f , however, the earnings are being retained for reinvestment as the second term (g2) implies, they are unavailable to the shareholders and should not be c a p i t a l i z e d . The only benefit that the shareholder w i l l derive from these retained earnings w i l l be a higher stock price i f the firm i s successful i n i t s reinvestment. Conversely, the earnings which are d i s t r i b u t e d to the shareholder are unavailable for reinvestment by the firm and should not be c a p i t a l i z e d i n the nth year. To avoid double counting i t i s necessary to es t a b l i s h the portion of earnings being d i s t r i b u t e d by the firm. Therefore: (b) w i l l represent the retained earnings and (1 - b) represents the dividends d i s t r i b u t e d in the current period. If the current stock price i s represented by (P) then: Pn + (1 + k ) n where Pn may be defined as: (8) P = Eo n nr i— • (1 + gs) 1" (1 - b) (1 + k ) t (9) Pn •= En (k - g2) Eo (1 + g)(1 + b ) n (k - g2) - 43 -Thus the normative value of the stock p r i c e i s equal to the p r e s e n t value o f i t s earnings d i s t r i b u t e d over a f i n i t e time p e r i o d p l u s the present value of i t s stock p r i c e i n year n. I f the f i r m r e t a i n s a l l i t s earnings (b = 1) the c u r r e n t s t o c k p r i c e i s equal t o the p r e s e n t value o f Pn. The amount of earnings i n year n w i l l depend on both the growth r a t e of the f i r m and the amount of r e t a i n e d e a r n i n g s . The more the f i r m r e t a i n s the g r e a t e r w i l l be the earnings i n year n due t o reinvestment. The more d i v i d e n d s t h a t are p a i d out the lower w i l l be the v a l u e of earnings i n year n (En) but the s h a r e h o l d e r w i l l r e c e i v e g r e a t e r d i v i d e n d s w i t h i n the f i n i t e time p e r i o d ( t ^ h ) . I f we combine equations 8 and 9 and d i v i d e by E Q the normative P r i c e - E a r n i n g s R a t i o may be s t a t e d : ^ n (1 + g) ( 1 + b ) n (10) P/E = * \ (1 + g s ) t (1 - b.) (k - g 2) t = 1 (1 + k)t (1 +: k ) n The f i r s t term d i s c o u n t s o n l y those earnings which are d i s t r i b u t e d t o the s h a r e h o l d e r . The l a s t term c o n s i d e r s o n l y those earnings which have been r e t a i n e d f o r reinvestment or Retained E a r n i n g s . I f the r e t e n t i o n r a t e , which i s assumed con s t a n t i s equal t o 1 then the f i r s t term, the r e t u r n t o the s h a r e h o l d e r , i s zero and the P r i c e Earnings R a t i o i s equal to the Present Value of the c a p i t a l i z e d earnings i n year n. However, i f a l l earnings are d i s t r i b u t e d t o s h a r e h o l d e r s over the f i n i t e time - 44 -horizon, (b = o) w i l l equate the current Price Earnings Ratio to the Present Value (Pv) of the dividends through year n i n addition to the discounted value of the Price-Earnings Ratio i n the nth year. Tables IA and IB present the Price-Earnings Ratios, where IA assumes the retention of a l l earnings within the f i n i t e time period while IB assumes t o t a l payout of a l l earnings. The formulation focuses an important determinant of the Price-Earnings Ratio - The Firms dividend p o l i c y . When the short term growth rate exceeds the discount rate (gs^»k), the Price-Earnings Ratio w i l l be p o s i t i v e l y related to the degree of earnings retained (b). The value of (k) represents not only the discount rate but also the investors opportunity cost of c a p i t a l . I f the firm can reinvest at a higher rate of return than the investor, then the investor w i l l be w i l l i n g to pay a premium to have the firm reinvest on his behalf. On the other hand, i f the firm i s unable to reinvest at a rate of return at least as great as the investor on his own, i t w i l l be discounted for greater retained earnings. APPLICATION Formulation (10) i s useful for investment decisions because i t focuses on the variables that concern the invest-ment manager, while i t defines i n a conceptually correct man-ner the value of a share of stock within the framework of the Price-Earnings Ratio. - 45 -By i n s e r t i n g the a p p r o p r i a t e v a l u e s f o r (gs) ( g l ) , (n), (k) and (b) , the a p p r o p r i a t e P r i c e - E a r n i n g s R a t i o may be determined. Or given a P r i c e - E a r n i n g s R a t i o , the assumed growth r a t e and i t s d u r a t i o n can be determined. T h i s permits a n a l y s t s to concentrate on the c o n t r i b u t i o n of these growth r a t e s t o the P r i c e Earnings R a t i o and g a i n a g r e a t e r i n s i g h t i n t o the p r o j e c t i o n o f the stock p r i c e . C onsider two Companies which have the same d i s c o u n t r a t e (k), s h o r t term growth r a t e s (gs) long term growth r a t e s (g2) and a f i n i t e time h o r i z o n . (See Table 11). TABLE 11 Firm A Firm B k = 10% k = 10% g 2 = 4 % g 2 = 4% n = 10 years n = 10 years b = 1 b = 0 Fi r m A r e t a i n s a l l i t s earnings w h i l e F i r m B d i s t r i b u t e s a l l i t s earnings t o the sh a r e h o l d e r s . When the s h o r t term growth r a t e (gs) i s 8%, Firm B has the h i g h e r P r i c e Earnings R a t i o because they immediately d i s t r i b u t e these earnings t o s h a r e h o l d e r s , r e i n v e s t i n g a t 10%, I f the s h o r t term growth r a t e i s 12% Fi r m A w i l l have the h i g h e r P r i c e - E a r n i n g s R a t i o . The d i f f e r e n c e i n the P r i c e - E a r n i n g s R a t i o of Firm A and B when gs = 12 r e p r e s e n t s the premium (20 - 17 = 3) - 46 -which investors are w i l l i n g to pay to have Firm A reinvest on t h e i r behalf. P/E i f gs P/E i f gs To determine the P/E: For Firm A For Firm B CONCLUSION 8% 12% b = 1 b = 0 Firm A 14 20 use TABLE IB use TABLE IA Firm B 15 17 The Price-Earnings Ratio i s a concept consistent with the p r i n c i p l e s of present value theory, derived from the present value formulae and assumes s p e c i f i c combinations of values for earnings growth, duration, discount rates and dividend payout. Therefore, investment managers and security analysts should focus on the assumption behind the value of each P r i c e -Earnings Ratio. While the ultimate decisions and price pro-jections w i l l always be i n the subjective, t h e i r relationship to the implied or expressed assumptions can be evaluated objectively. CHAPTER V INDEX TO FOOTNOTES Earl M. Foster, Ph. D., Professor of Finance, Boston University, Price Earnings Ratio  and Corporate Growth, Fin a n c i a l Analysts Journal, January-February, 1970. The Present Value of a $1.00 i n ten years i s 39C; i n 20 years i t i s only 15C. Many Dividend C a p i t a l i z a t i o n Models are Expanded from this Basic Form. TABLE IA P/E Ratio and Corporate Growth (Assuming k = 10%, g2 = 4% and b = 0) gs % - 1 0 -8 - 6 - 4 - 2 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 Year 1 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 2 15 15 15 15 15 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 16 17 17 17 3 15 15 15 15 15 15 15 15 15 15 16 16 16 16 16 16 16 16 16 17 17 17 17 17 17 17 4 14 14 14 14 14 15 15 15 15 15 15 16 16 16 16 16 17 17 17 17 18 18 18 18 19 19 5 13 13 14 14 14 14 14 15 15 15 15 16 16 16 17 17 17 18 18 18 19 19 20 20 21 21 6 13 13 13 13 13 14 14 14 15 15 15 16 16 17 17 18 18 19 19 20 21 21 22 23 24 25 7 12 12 12 13 13 13 14 14 15 15 16 16 17 17 18 19 19 20 21 22 23 24 25 26 28 29 8 11 12 12 12 13 13 14 14 15 15 16 16 17 18 19 20 21 22 23 25 26 28 29 31 33 35 9 11 11 12 12 12 13 13 14 15 15 16 17 18 19 20 21 23 24 26 28 30 32 34 37 40 43 10 10 11 11 12 12 13 13 14 15 15 16 17 19 20 21 23 25 27 29 32 34 38 41 45 49 54 11 10 10 11 11 12 12 13 14 15 16 17 18 20 21 23 25 27 30 33 36 40 44 49 55 61 67 12 9 10 10 11 11 12 13 14 15 16 17 19 21 23 25 27 30 34 38 42 47 53 59 67 75 85 13 9 9 10 11 11 12 13 14 15 16 18 20 22 24 27 30 34 38 43 49 55 63 72 82 94 107 14 9 9 10 10 11 12 13 14 15 17 18 20 23 26 29 33 38 43 49 57 65 75 87 101 117 136 15 8 9 9 10 11 12 13 14 15 17 19 21 24 28 32 36 42 49 56 66 77 90 106 125 147 173 16 8 8 9 10 11 11 13 14 15 17 20 22 26 30 34 40 47 55 65 77 91 109 129 154 184 220 17 8 8 9 9 10 11 13 14 16 18 20 23 27 32 37 44 52 62 75 90 108 130 158 191 231 280 18 7 8 9 9 10 11 12 14 16 18 21 24 29 34 40 48 58 71 86 105 128 157 192 236 290 357 19 7 8 8 9 10 11 12 14 16 19 22 26 30 36 44 53 65 80 99 122 152 188 235 292 364 454 20 7 7 8 9 10 11 12 14 16 19 22 27 32 39 48 59 73 91 114 143 180 227 286 362 457 578 <7~ TABLE IB P/E Ratio and Corporate Growth (Assuming k = 10%, g2 = 4%, and b = 1.0) gs % -10 - 8 - 6 - 4 - 2 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 40 Year 1 14 14 14 15 15 15 15 16 16 16 17 17 17 18 18 18 18 19 19 19 20 20 20 21 21 21 2 11 12 12 13 13 14 14 15 15 16 17 17 18 19 19 20 21 21 22 23 23 24 25 25 26 27 3 9 10 10 11 12 13 13 14 15 16 17 18 19 20 21 22 23 24 25 26 28 29 30 31 33 34 4 7 8 9 10 10 11 12 13 14 15 17 18 19 21 22 24 25 27 29 31 33 35 37 39 41 44 5 6 7 8 8 9 10 11 13 14 15 17 18 20 22 24 26 28 30 33 36 38 41 45 48 52 56 6 5 6 6 7 8 9 11 12 13 15 17 19 21 23 25 28 31 34 38 41 45 50 54 60 65 71 7 4 5 6 6 7 9 10 11 13 15 17 19 21 24 27 31 34 39 43 48 54 60 66 74 82 90 8 3 4 5 6 7 8 9 11 12 14 17 19 22 25 29 33 38 43 49 56 63 72 81 91 102 115 9 3 3 4 5 6 7 8 10 12 14 17 20 23 27 31 36 42 49 57 65 75 86 98 113 128 146 10 2 3 3 4 5 6 8 10 12 14 17 20 24 28 34 40 47 55 65 76 89 103 120 139 161 186 11 2 2 3 4 5 6 7 9 11 14 17 20 25 30 36 43 52 62 74 88 105 124 146 172 202 237 12 1 2 3 3 4 5 7 9 11 13 17 21 26 32 39 47 58 70 85 103 124 149 178 213 253 301 13 1 2 2 3 4 5 6 8 10 13 17 21 27 33 42 52 64 79 97 120 146 178 217 263 318 383 14 1 1 2 2 3 4 6 8 10 13 17 21 27 35 45 56 71 89 112 139 173 214 264 325 399 488 15 1 1 2 2 3 4 5 7 10 13 17 22 28 37 48 61 79 101 128 162 204 257 322 402 500 621 16 1 1 1 2 3 4 5 7 9 12 17 22 30 39 51 67 87 113 146 188 241 308 392 497 628 790 17 1 1 1 2 2 o «> 5 6 9 12 17 23 31 41 55 73 97 128 168 219 285 370 477 614 787 1005 18 0 1 1 1 2 3 4 6 9 12 17 23 32 43 59 80 107 144 192 255 337 444 582 759 988 1280 19 0 1 1. 1 2 3 4 6 8 12 17 23 33 46 63 87 119 162 220 297 398 532 709 939 1239 1629 20 0 0 1 1 2 2 4 5 8 12 17 24 34 48 68 95 132 183 252 345 471 639 863 1161 1554 2073 - 47 -CHAPTER VI THE CONCEPT OF SUSTAINED GROWTH The demand in pension trusts today i s for "Perform-ance" i n the sense of price appreciation plus dividend y i e l d . Today, higher taxes and higher prices have combined to make dividends the less important part of t h i s t o t a l y i e l d concept. This approach has one major constraint, the ap-pr e c i a t i o n must be "taken" at some given period since "the tree doesn't grow to the sky". In spite of t h i s constraint, the word performance has become a synonym for price appreciation. Many writers, l i k e G u i l f o r d C. Babcock, f e e l that th i s increased i n t e r e s t i n prices and price changes has led security analysts i n two d i f f e r e n t d i r e c t i o n s . There i s an increased emphasis on technical analysis. The use of charts and other techniques to develop patterns of price and volume which 2 they believe have some predictive value. - Second, there i s beginning a more systematic analysis of the basic elements of price appre-c i a t i o n , namely, higher earnings and higher mul-t i p l e s , but with a systematic approach to the problem and the e x p l i c i t recognition that these elements are only a means to the goal of price - 48 -3 a p p r e c i a t i o n , b o t h l o n g term and s h o r t term. The p r i c e P o f any s t o c k can be e x p r e s s e d a s : P = m x E (1) when m s t a n d s f o r t h e m u l t i p l i e r o r P/ER and E st a n d s f o r e a r n i n g s p e r share f o r some ac-c o u n t i n g p e r i o d . T h e r e f o r e , t h e p r i c e movement o f any s t o c k from one p e r i o d t o a n o t h e r can be e x p r e s s e d a s : P„ _ m_ x E„ __ m E — ~ — ~ — X — (2) P l m l X E l m l E l The s u b s c r i p t s denote s u c c e s s i v e time p e r i o d s . In t h e o r y t h e n , s t o c k - p r i c e s changes a r e d e t e r m i n -ed by t h e s e two e l e m e n t s . THE BASIC EQUATION The EPS o f any Company, f o r any p e r i o d o f t i m e , may be e x p r e s s e d d i r e c t l y as t h e p r o d u c t o f f i v e v a r i a b l e s : M x T x L x U x B = E (3) where M i s t h e margin o f p r o f i t from s a l e s , T i s t h e t u r n o v e r r a t i o o f s a l e s t o t o t a l c a p i t a l , L i s t h e e f f e c t o f l e v e r a g e employed, U i s the a f t e r t a x r a t e o r U = 1 - t where t i s the t a x r a t e , B i s the e q u i t y o r book v a l u e o f a common s h a r e . - 49 -Equation (3) i s an i d e n t i t y which relates the trad-i t i o n a l r a t i o s of f i n a n c i a l analysis to the earnings per share for the period. Therefore, any change i n earnings can be expressed as changes i n these f i v e variables: M2 T 2 L 2 U 2 B 2 E 2 x x x x = (4) M l T l L l U l B l E l However changes i n margin, turnover, leverage and the rate of earnings aft e r taxes, cannot be r e l i e d upon to sustain growth over a long period of time. S p e c i f i c a l l y -changes i n margin w i l l always occur but upward movements w i l l be l i m i t e d by the degree of competition i n the industry. Changes i n turnover are almost i n e v i t a b l e , but plant capacity or the state of technology w i l l l i m i t the volume of sales r e l a t i v e to t o t a l c a p i t a l . The degree of leverage available to a company i s limited either by the willingness of creditors or by pru-dence of management. Governments at a l l lev e l s can be r e l i e d upon to l i m i t the number of tax concessions as a continuing source of growth. In any one period changes i n these four variables may be c r i t i c a l i n determining the l e v e l of earnings; how-ever, over time, they a l l have a tendency to fluctuate about some normal value, depending on the nature of the industry and the l e v e l of the economy. - 50 -On the other hand, changes i n book value can occur r e g u l a r l y i n an upward d i r e c t i o n through r e t a i n e d e a r n i n g s . T h i s i s the o n l y s u s t a i n a b l e source o f growth a v a i l a b l e t o the 4 company. Changes i n B can be expressed d i r e c t l y i n terms o f M, T, L and U. Thus changes i n E.P.S. depend d i r e c t l y on changes i n M, T, L and U and the absolute value o f these same v a r i a b l e s . The remainder of t h i s chapter w i l l d e f i n e the terms i n Equation (3) and then develop Equation (4) as an a n a l y t i c t o o l which can break down the growth r a t e i n r e p o r t e d earn-ings to S u s t a i n a b l e and U n s u s t a i n a b l e components. The s u s t a i n a b l e component w i l l be a s s o c i a t e d w i t h the normal e a r n i n g power of the company based on M, T, L and U. The u n s u s t a i n a b l e component w i l l be shown to r e p r e s e n t f l u c t u a t i o n s above or below the s u s t a i n a b l e r a t e . Here we attempt to i s o l a t e the important v a r i a b l e s i n order to f a c i l i t a t e a more d e t a i l e d a n a l y s i s of the v a r i o u s p e r i o d s i n q u e s t i o n . B a s i c D e f i n i t i o n s : TA - T o t a l A s s e t s CL - Current L i a b i l i t i e s TC - T o t a l C a p i t a l TA - CL LTL - Long Term L i a b i l i t i e s or Debt NW - Net Worth CE - Common E q u i t y B - Book Value per Share. - 51 -TR - T o t a l Revenue or i n f l o w of a s s e t s EBIT - Earnings b e f o r e I n t e r e s t and Taxes EBT - Earnings b e f o r e Taxes EAT - Earnings a f t e r Taxes E - Earnings per Share (EPS) Margin x Turnover = Return M = EBIT/TR (5) Since M holds t o t a l p r o f i t a g a i n s t t o t a l revenue i t i s an aggregate measure o f p r o f i t a b i l i t y per d o l l a r of revenue. Turnover i s d e f i n e d as the r a t i o of t o t a l revenue to t o t a l c a p i t a l . T = TR/TC (6) Hence T i s an aggregate measure o f revenue per d o l l a r of c a p i t a l . T h e r e f o r e r e t u r n on t o t a l c a p i t a l i s d e f i n e d as the r a t i o o f EBIT t o TC and may be w r i t t e n : R T C =• EBIT/TC = M X T (7) T h i s e q u a t i o n may be r e c o g n i z e d as the "DuPont Formula". Return here i s based on the TC e x i s t i n g at the end of the p e r i o d but a good case can be put up f o r u s i n g average i n v e s t e d c a p i t a l . E quation (7) i s important f o r two reasons: F i r s t , i t d i s t i n g u i s h e s between the concept of r e t u r n and the concept o f margin -- r e t u r n r e f e r s to p r o f i t i n r e l a t i o n t o investment w h i l e margin r e f e r s to p r o f i t i n r e l a t i o n t o sales or revenue. Second, the formula properly puts the focus on return as the goal of investment and only on margin as a means to that goal. Therefore, low margin i s not bad i f the turnover i s high. The rate of return on t o t a l c a p i t a l i s only one measure of return and c e r t a i n l y not the one of most i n t e r e s t to the stockholder. The t y p i c a l investor i s assumed to have a primary i n t e r e s t i n the rate of return on his own investment, which i s i n the stock market. Therefore i t must be shown that R, as defined above has a d i r e c t bearing on the growth of earn-ings which underlies the stock market investment. THE EFFECT OF LEVERAGE If the c a p i t a l of a company i s provided only by shareholders equity, then the rate of return on TC i s the rate of return on equity. The rate return on equity i s a function of the growth rate of earnings. However, c a p i t a l i s usually provided by some combination of debt and equity which should lever or raise the rate of return on equity. Therefore, a useful measure of leverage i s one which indicates how much the rate of return has been raised. For example - i f the rate of return on t o t a l c a p i t a l R r r , c = 20% and one-half of the c a p i t a l i s provided by debt costing 8%, the pretax net worth i s 1/2 (8%) + 1/2 (R N W) = 20% ( V = 32 % R ^ i s the rate of return on net worth before taxes. Hence the debt raised the rate of return from 20% on t o t a l c a p i t a l to 32% on net worth or equity, that i s , by factor T RNW EBT/NW , £ n ,. , O N L B • = ' = 1.60 times (8) R T C EBIT/TC where L stands for the leverage e f f e c t (before taxes) of long term l i a b i l i t i e s . However, we must recognize an after tax leverage e f f e c t which w i l l e x i s t i f any preferred stock i s out-standing. Whereas L D shows how much the rate of return before taxes w i l l be raised by the long term l i a b i l i t i e s , shows how much the rate of return w i l l be raised by the use of pre-ferred stock. T _ rCE _ EAC/CE L A ~ ~ r N W EAT/NW (9) where r_,_ i s the rate of return on common equity and r. T T T re-CE - . NW presents the rate of return on net worth. and L,. are di r e c t D A measures of the effect of using someone else's money. L w i l l only be greater than 1.0 i f the rate of return on t o t a l c a p i t a l i s greater than the int e r e s t on the borrowed funds. S i m i l a r l y L A w i l l only be greater than 1.0 i f the rate of return on t o t a l equity (net worth) i s greater - 54 -than the preferred dividend requirements. If and L A are less than 1.0 the leverage e f f e c t w i l l be negative. THE EFFECT OF INCOME TAXES The e f f e c t of leverage i s intended to ra i s e the rate of return to the stockholders; on the other hand the inevitable e f f e c t of taxes i s to lower that rate of return. For example, i f we assume a 50% tax rate, t = .50, the af t e r tax rate of return w i l l be lowered by a factor U = ( i - t) or from 32% to 16%. In general t h i s r e l a t i o n s h i p can be: *NW ( 1 " t } = rNW or, **NW X U = rNW (10) U i s the portion of earnings before taxes that get through to net income. RETURN ON COMMON EQUITY Here we w i l l show how the concepts of margin, turn-over, leverage and taxes combine to y i e l d return on common equity. M = margin of p r o f i t to sales (5) M x T = return on TC (7) M x T x L_, = return on NW before taxes (8) M x T x L x U = return on NW after taxes (10) a M x T x L _ x U x T _ = return on common equity (9). The l a s t term can be s i m p l i f i e d i f we l e t L = L B x L A represent the t o t a l leverage e f f e c t of long term debt and pre-- 55 -5 r f erred stock, and i f we l e t r = then M x T x L x U = r. Then margin, turnover, leverage, and taxes have a d i r e c t e f f e c t on Y and E, the EPS of the common stockholders. Return on CE has been defined as the r a t i o of t o t a l earnings available for the common stockholders to the t o t a l equity of the common stockholders and can be expressed on a per share basis. EAC E where E i s EPS and B i s book value. Combining t h i s r e s u l t with Equation (11) our basic equation for EPS becomes: M x T x L x U x B = E (EPS) (3) This i s an i d e n t i t y where the two sides are equal by d e f i n i t i o n and since M, T, L and U are not independent var-iables and the equation cannot be used as a forecasting t o o l . But they do correspond to the variables which corporate man-agers try to control and f i n a n c i a l analysts seek to forecast. Hence Equation (3) provides a l o g i c a l framework for analyzing the common variables and t h e i r relationship to EPS. EXHIBIT 6.1 shows the application of thi s basic equation to the DJIA. CHANGES IN EARNINGS PER SHARE Since Equation (3) above holds for every period, therefore: - 56 -ML T„ L„ U, B0 _ E0 _ £ x — x — x — x — ~ — (4) M l T l L l U l B l E l Hence Equation (4) i s the basic equation for changes i n earnings. It simply states that any change i n EPS i s a function of changes i n the underlying variables but M,T,L and U cannot be r e l i e d upon to sustain growth, although they w i l l induce fluctuations i n the earnings stream. However, changes in book value can sustain growth provided the firm earns a p r o f i t and retains a portion of i t . CHANGES IN BOOK VALUE Any change i n book value can be attributed to re-tained earnings and. other sources such as new equity financing. Hence the difference i n book value between one period and the next can be expressed as -B 2 " B l = b 2 E 2 + X2 (13) Where i s the portion of earnings retained, 1>2E2 ^ o r * -^ e d o l l a r amount per share retained, and X^ the d o l l a r amount of change due to a l l other sources including equity financing, mergers, or certain changes i n accounting procedures, i e . , LIFO or FIFO, etc., X,, then i s a l l other factors. The r a t i o os to B^ can now be written: B 2 = B l + X2 , B2 B l B l B2 ~ b 2 E 2 This expression separates the external component of - 57 -change which i s n o n - r e c u r r i n g from the r e t a i n e d earnings com-ponent which i s s u s t a i n a b l e . T h i s second f a c t o r i s the b a s i s of earnings growth and i n i t i a l t e s t s o f the DJIA show t h a t i t seems to c o r r e l a t e w i t h both performance p r i c e a p p r e c i a t i o n and r e c o g n i t i o n (the m u l t i p l i e r ) shown i n EXHIBIT 6.2. By r e a r r a n g i n g the terms of Equation (14) and then by s u b s t i t u t i o n from Equations (13) and (11) we w r i t e : h. 1 + i-i 1 B l B l X 1 - b 2 E 2 / B 2 1 + X 1 X B l  1~*2*2 ~l •+- y _2 x 1 (15) B l ^ 2 T2 L 2 °2 Any change i n book value then, i s f u l l y e x p l a i n e d by non-r e c u r r i n g e x t e r n a l f a c t o r s , by the ab s o l u t e v a l u e o f M, T, L and U and by the r e t e n t i o n r a t e b. CONCLUSION By s u b s t i t u t i n g the r e s u l t s o f Equation (15) i n t o Equation (4), we have our f i n a l e x p r e s s i o n f o r changes i n EPS. !^x ! i x ^ ^ 1 + X 2 = M l T l L l U l B l E 2 1 - M 2 T 2 L 2 U 2 b 2 E x ( 1 6 ) - 58 -Hence any changes i n EPS i s a function of six variables: 1 - Margin and changes i n margin. 2 - Turnover and changes i n turnover. 3 - Leverage and changes i n leverage. 4 - Tax rates and changes i n tax rates. 5 - External factors which a f f e c t book value. 6 - Retention rate. The f i r s t four factors i n Equation (16) which repre-sent changes i n key variables w i l l cause fluctuations i n the earnings stream as w i l l the f i f t h term "external factors". Only the f i n a l factor, retention rate, which i s a function of the absolute value of the key variables, can be viewed as a sustainable source of growth. However, wuch growth i s only sustainable to the ex-tent, margin turnover, leverage and taxes are maintained at current l e v e l s . The data contain no such guarantee for the future, although a look at the h i s t o r i c a l values of MTL and U may Rel'pndef ine the normal earning power of the company. What the data of equation (16) do contain i s a growth rate which w i l l p r e v a i l , mutatis mutandis, but whether or not other things are equal remains within the purview of the an-a l y s t who has a working knowledge of the company, the industry and the economy. A NUMERICAL EXAMPLE Since Equation (16) requires reference data for ease of comprehension, the following i l l u s t r a t i o n i s shown below - 59 -for a company whose earnings increased by 11%, 76% and 18% i n three successive years. /66 /67 /68 /69 Margin Turnover Leverage U = (1 - t) .02 10X 1.60 . 50 .02 10X 1.60 . 50 .03 10X 1.60 .50 . 03 10X 1.60 . 50 r Book Value .16 9.00 .16 10.00 . 24 11.76 .24 13.84 E D 1.44 -.54 1.60 -.60 2.82 -1.06 3.32 -1.24 Retained b rb .90 5/8 .10 1.00 5/8 .10 1.76 5/8 . 15 2.08 5/8 .15 1 1.11 1.11 1.18 1.18 1 - rb E2 E l 1.11 1.76 1.18 EX7AMPLE 6.1 During the f i r s t year earnings growth and sustainable growth were equal so no change occurs i n M,T,L and U. During year two margin i s increased by a factor of 1.50, that i s , from .02 to .03. As a r e s u l t earnings increase by a factor of 1.76, that i s , 1.5 times the new sustainable growth factor of 1.18. During the t h i r d year earnings growth and sustain-able growth are equal, as M, T, L and'JU are held constant. However, i t should be noted that they are equal at the rate of 18% which was discovered during the previous year. In other - 60 -words, the 76% growth r a t e of the second year came w i t h i t s own "caveat i n v e s t o r " . I t can a l s o be shown t h a t earnings w i l l d e c l i n e by 26% on a year t o year b a s i s , i f margin now drops back to .02. In any event, the f i n a l term i n Equation (16) w i l l r e v e a l the o l d growth p o t e n t i a l of 11% per annum based on the o l d l e v e l s of M, T, L and U. Hence Equation (16) not o n l y c o n t a i n s a warning i f earnings r i s e too f a s t , i t a l s o c o n t a i n s a promise i f they do not r i s e f a s t enough. F i n a l l y , the r e l a t i o n s h i p of these v a r i a b l e s to the stock market i t s e l f should be noted. EXHIBIT 6.1 p r o v i d e s a r a t i o a n a l y s i s f o r the stocks i n the DJIA based on 1965 data. EXHIBIT 6.2 ranks the 30 stocks on the b a s i s o f sus-t a i n a b l e growth c a l c u l a t e d over an e l e v e n year p e r i o d from 1954 to 1965. I t shows t h a t the top ten stocks on t h i s b a s i s not o n l y had the g r e a t e s t p r i c e a p p r e c i a t i o n f o r the p e r i o d , 13.9% per annum compared t o 5.0% f o r the lowest group, they a l s o con-t i n u e d t o s e l l a t the h i g h e s t p r i c e s i n r e l a t i o n t o 1965, 21.0 times earnings compared to.14.2 times f o r the lowest group. Whether or not t h i s type o f a n a l y s i s can be p r o f i t a b l y adopted to s h o r t e r p e r i o d s of investment i s an open q u e s t i o n ; however, the r e s u l t s here c e r t a i n l y argue i t s m e r i t s f o r the long term i n v e s t o r . CHAPTER VI INDEX TO FOOTNOTES See Irving Fisher, How to Invest when Prices  are Rising, :(..G. Lynn Summer & Co. 1912) See Paul Cootner, The Random Character of Stock Market Prices, (The M.I.T. Press, 1964), Robert A. Levy, "Random Walks: Reality or Myth", Fin a n c i a l Analysts Journal, March-April, 1969. See S. Francis Nicholson, "Price Ratios", F i n a n c i a l Analysts Journal, January-February, 196 8. The Concept of "Sustainable Growth" i s Es-s e n t i a l l y the Same as the Concept of "Supportable Growth", developed by Manown K-isor, J r . , Financial Analysts Journal, March-April, 1964. This D e f i n i t i o n of Once-All Leverage i s Identical to the Concept of "trading on the equity" developed by Pearson Hunt, "A Proposal for Precise Definitions of Trading on the Equity and Leverage". Journal of Finance^.lXVI, 1961. EXHIBIT 6.1 T H E D J I A STOCKS: Ratio Analysis of 1965 Earnings M X T (=R) X L X U <=r) X B = E Allied Chemical 12.7 . 1.00 2.6 1.58 .64 12.8 24.00 $3.08 Alcoa , 12.3 .77 10.7 1.44 .63 8.7 39.39 3.41 American Can 9.8 1.43 14.0 1.42 .54 10.8 33.51 3.61 A T & T 32.5 .37 12.1 1.40 .55 9.3 . 36.61 3.39 American Tobacco 22.9 1.07 24.5 1.07 .51 13.3 22.84 3.05 Anaconda 17.7 .82 14.5 1.07 .46 7.2 101.25 7.27 Bethlehem Steel 10.6 1.27 15.9 1.15 .57 8.8 37.13 3.26 Chrysler 8.6 2.69 23.1 1.27 .52 15.3 33.78 5.16 duPont . .." 25.7 1.28 32.9 1.21 .52 20.8 41.58 8.63 Eastman Kodak 32.4 1.40 45.3 1.02 .52 24.2 12.71 3.07 General Electric 11.8 2.27 26.9 1.24 .50 16.7 23.36 3.90 General Foods 12.0 2.44 29.3 1.14 .51 17.0 21.99 3.73 General Motors 19.8 2.28 45.2 1.16 .52 27.3 27.13 7.40 Goodyear Tire 9.6 1.75 16.9 1.32 .55 12.1 25.20 3.06 International Harvester . . 8.7 1.73 15.1 1.11 .54 9.1 38.16 3.46 International Nickel 37.4 .73 27.2 . 1.09 .61 18.1 26.86 4.85 International Paper 11.6 1.31 15.3 1.02 .58 9.1 22.16 2.02 13.2 1.45 19.2 1.02 .54 10.5 38.29 4.03 Owens Illinois 11.6 1.17 13.7 1.22 .57 9.5 35.55 3.38 Procter & Gamble 12.6 1.92 24.1 1.11 .53 16.3 21.76 3.08 Sears 10.2 2.44 , 9 24.9 1.08 .55 14.9 14.27 2.12 Standard Oil, Calif 19.1 .69 13.2 1.06. .86 12.0 42.54 5.10 Standard Oil, (N.J.) 15.4 1.08 16.6 1.16 .62 11.9 40.27 4.81 Swift 1.1 5.13 5.8 1.10 .63 3.9 68.56 2.70 Texaco 19.7 .81 16.0 1.11 .88 15.6 30.31 4.71 Union Carbide 19.1 1.04 20.0 1.39 .61 16.9 22.29 3.76 United Aircraft 6.8 3.05 20.7 1.18 .55 13.2 32.84 4.33 U . S. Steel 12.3 .98 12.1 1.14 .54 7.4 62.48 4.62 Westinghouse 8.6 1.77 15.2 1.29 .54 10.7 26.69 2.86 Woohvorth nr. 1.15 S.f. 1.10 rr,-> . < e- 3 6. *3 ii O ^ i Average 15.1 1.58 19.7 1.19 .58 13.0 34.66 4.03 IXHIBIT 6 . 2 T H E D J I A STOCKS: • 1 Sustainable Growth, gs = , Based on 1965 Data and 1954-1965 Data 1 - rb • 1965 Data 1951-1965 Data 1965 r b Ss r b Is P/E Texaco 15.6 .48 8.1 15.1 .54 ' 8.9 15.6 17.1 General Foods 17.0 ..44 8.0 17.1 .46 8.5 15.5 22.4 Goodyear Tire 12.1 .61 8.0 12.7 .62 8.4 13.8 16.2 Eastman Kodak 24.2 .42 11.2 17.9 .41 7.9 19.8 30.4 Standard Oil, Calif 12.0 .56 7.2 13.1 .56 7.9 9.7 14.3 General Motors 27.3 .29 8.6 21.6 .33 7.6 13.1 13.8 Sears 14.9 .47 7.5 14.2 .49 7.5 18.1 32.8 Procter & Gamble 16.3 .41 6.2 15.0 .44 7.2 14.9 24.5 International Nickel 18.1 .37 7.2 16.9 .38 •• 6.8 12.7 18.0 Alcoa 8.7 .59 5.4 9.6 .55 5.6 5.8 20.5 Top 10 Average 16.6 .46 7.7 15.3 .48 7.6 13.9 21.0 General Electric 16.7 .39 7.0 17.1 .30 5.4 9.6 27.1 Chrysler 15.3 .77 13.2 8.4 .61 5.4 11.7 10.0 American Tobacco 13.3 .46 6.5 12.6 .40 . 5.3 8.4 i2.1 Union Carbide 16.9 .47 8.6 15.8 .30 5.0 4.8 17.8 International Paper 9.1 .38 3.6 10.3 .46 4.9 5.1 15.9 Standard Oil, (N.J.) 11.9 .34 4.3 12.1 .38 4.8 9.4 17.0 duPont 20.8 .30 6.8 19.6 .22 4.5 55.4 28.2 United Aircraft 13.2 .70 10.2 13.1 .33 4.5 10.2 15.5 Owens Illinois 9.5 .60 6.1 8.7 .46 4.2 8.9 17.3 Allied Chemical 12.8 .40 5.4 11.4 .34 4.0 2.3 16.4 Middle Average 14.0 .48 7.2 12.9 .39 4.8 7.6 17.7 Johns-Manville 10.5 .49 5.4 10.3 .36 3.9 3.8 14.3 U.S. 3 t . » l 7.4 .57 4.4 8.9 .41 3.8 c r H.C A T & T 9.3 .40 3.8 8.8 .35 3.2 8.0 19.2 Bethlehem Steel 8.8 .54 5.0 9.2 .29 2.7 6.0 11.7 Westinghouse 10.7 .57 6.5 7.3 .37 2.7 4.4 18.3 International Harvester . . 9.1 .57 5.4 6.6 .39 2.6 8.5 11.6 Anaconda 7.2 .48 3.6 6.2 .40 2.5 5.0 9.6 American Can 10.8 .43 4.9 9.2 .27 2.5 1.6 14.0 Woolworth 6.8 .60 4.3 4.9 .44 2.2 5.9 11.8 Swift 3.9 .26 1.0 4.3 .25 1.1 1.5 20.3 Bottom Average 8.5 -.49 4.4 7.6 .35 2.7 5.0 14.2 30 Stock Average 13.0 .48 6.5 11.9 .41 5.0 8.8 17.6 - 61 -CHAPTER VII THE USEFULNESS OF THE PRICE EARNINGS RATIO IN THE VALUATION OF STOOCKS  INTRODUCTION Although there are numerous methods used i n the valuation of common stocks, the Price Earnings Ratio (P/ER) i s probably the most commonly used c r i t e r i o n . The immediate ad-vantage of the (P/ER) i s that i t allows comparison of any num-ber of stocks i n terms of a common earnings base. Its importance can be evidenced by the every day use of t h i s r a t i o by investors, i n the p r i c i n g of new common stock issues by investment bankers, i n investment research reports and i n t h e o r e t i c a l and emperical models used i n the determin-ation of common stock price s . The Price Earnings Ratio i s even determined for the popular indecise such as the DJIA, Standard and Poors, the TSEIA and others and these r a t i o s aresshown not only for the current day but also for the past week, month and year and i s the basis for the Relative Value Technique used by many analysts. Since the P/ER i s the number of times of earnings per share at which a certain stock i s s e l l i n g , the term can be ambiguous i f the time horizon of both the numerator and denom-inator are not c l e a r l y defined. The denominator, earnings, must be c a r e f u l l y determined when comparing stocks since the determination of earnings per share can vary widely depending - 62 -on the accounting methods used by the firm. The r a t i o may be N times earnings for a future period, or N times average earn-ings for a past period, but most l i k e l y the concept of the P/ER i s applied to what i s considered a current f u l l year's figure. MARKET OR INDUSTRY P/E RATIO COMPARISON Security analysts generally begin t h e i r attempt to assign the appropriate P/E r a t i o to a stock by an analysis of the Market P/E r a t i o as a whole, or by an analysis of the P/E rat i o s of other companies i n the same industry. Considering the Market P/E r a t i o f i r s t , many analysts assume that an ap-propriate P/E r a t i o i s an average of say, the l a s t 5 or 10 years. The table reproduced below indicates the high and low P/E ra t i o s on the Standard and Poor I n d u s t r i a l , Railroad and U t i l i t y Stock Price Indicese for the 10 years 1956 - 1965. TABLE 7.1 Price-Earnings Ratios on Standard & Poor's Stock Prince Indexes, 1956-1965 INDUSTRIALS RAILS UTILITIES High Low High Low High Low 1956 15.1 13.0 9.4 7.6 15. 3 14.0 1957 15.2 12.0 10.1 6.5 15.2 12.9 1958 20. 0 14.6 11.9 7.5 18. 3 13.6 1959 18. 5 16.2 12. 5 10.5 19.1 17.6 1960 19. 3 16. 8 14. 3 11.1 19.2 16. 3 1961 22.8 18.1 16. 4 13.8 24.4 18.4 1962 19.4 14.2 11. 9 9.2 21.3 16.4 1963 18.7 15.4 12. 8 10. 3 21.1 19.0 1964 18.9 16.5 14.0 11.4 21.4 19. 0 1965 17.9 15. 7 13. 0 10. 3 20.2 18. 6 SOURCE: Investment Analysis & P o r t f o l i o Management , Cohen & Homewood, Zinborg, Richard D. Irwin Co. Inc., 1967, I l l i n o i s , p. 239. - 63 -Calculating the 10 year average P/E r a t i o for the Industrials gives us an average of approximately 17 with a range of 12.0 to 22.8. Similar calculations for the Rails and U t i l i t i e s y i e l d an average of 11 and a range of 7 to 17 and an average of 18 and a range of 13 to 24 respectively. Looking now at the various industries, we are again presented with an array of P/E r a t i o s . Reproduced bwlow i s part of a table compiled to display the P/E r a t i o s of 50 com-panies from 25 i n d u s t r i e s . From t h i s table we can make a number of observations. TABLE 7.2 Price-Earnings Ratios of Selected Companies 1961-1965 Industry Company 1961 1962 196 3 1964 1965 A i r l i n e s American 15 19 12 11 13 Pan American 15 9 7 13 13 Automobiles Chrysler 34 8 8 9 10 General Motors 16 10 13 15 14 Building Johns-Manvilie 20 17 14 15 14 Materials ' National Gypsum 16 13 13 15 15 Cement Lone Star 15 11 12 13 10 Marquette 17 13 12 13 15 Drugs Merck 32 29 28 31 34 Parke-Davis 20 18 20 18 14 Tires Goodyear 18 16 16 16 16 U.S. Rubber 12 12 13 12 12 Of f i c e j I B M 54 40 34 37 36 Equipment Burroughs 23 27 20 18 16 Soft Drinks Coca-Cola 30 26 27 27 30 Pepsi-Cola 24 19 21 20 22 SOURCE: Ibid., pp. 244-245. F i r s t , the market values the earnings of some i n -dustries higher than others. Second, the market values the earnings of companies - 64 -i n the same i n d u s t r y d i f f e r e n t l y . T h i r d , we see a s i g n i f i c a n t change i n the r a t i o s over the f i v e year p e r i o d . The average r e l a t i o n s h i p between p r i c e and earnings r e f l e c t s the view of i n v e s t o r s as to the q u a l i t y of the stock. A s t r o n g , s u c c e s s f u l , promising company w i l l s e l l a t a h i g h e r m u l t i p l e of c u r r e n t and average earnings than<one o f l e s s e r q u a l i t y . From TABLE 7.2 i t can be seen t h a t the market t y p i c -a l l y has valued the earnings of some l e a d i n g companies i n r e -s p e c t i v e i n d u s t r i e s more h i g h l y than the c l o s e s t c o m p e t i t o r s . I n t e r - i n d u s t r y and inter-company d i f f e r e n c e s i n P/E r a t i o s may r e f l e c t d i f f e r e n c e s i n the expected growth r a t e o f e a r n i n g power, the p a s t growth of s a l e s and e a r n i n g s , d i v i d e n d p o l i c i e s , c a p i t a l s t r u c t u r e s and "corporate image". The a n a l y s t must now decide what f a c t o r s t o c o n s i d e r i n determining the P/E r a t i o of h i s p a r t i c u l a r stock. Should he use the P/E r a t i o o f the whole market i n h i s d e c i s i o n or should he use the P/E r a t i o s of the p a r t i c u l a r i n d u s t r y of t h a t company? To answer t h i s q u e s t i o n we might u s e f u l l y c o n s i d e r one study conducted by W i l l i a m Breen. ^ T h i s study sought to t e s t whether a low P/E m u l t i p l e i s more p r o p e r l y an i n d u s t r y -r e l a t i v e concept or a m a r k e t - r e l a t i v e concept by performing a s t r a i g h t f o r w a r d s i m u l a t i o n of the performance o f two p o r t -f o l i o s . Each p o r t f o l i o i s chosen from the same p o p u l a t i o n , and each s o n s i s t s of low m u l t i p l e s e c u r i t i e s . In one p o r t f o l i o P/E r a t i o s are measured r e l a t i v e t o the market, w h i l e i n the second s e c u r i t i e s are chosen whose P/E r a t i o s are low r e l a t i v e - 65 -to the i n d u s t r y . Using t h i s method, Breen hopes to i s o l a t e the more p r o d u c t i v e d e f i n i t i o n of low P/E m u l t i p l e s . He judges the p o r t f o l i o w i t h the c o n s i s t e n t l y h i g h e r r e t u r n ( i f one e x i s t s ) to designate the more p r o d u c t i v e and u s e f u l d e f i n i t i o n o f low P/E r a t i o s . In o r d e r to e l i m i n a t e those companies t h a t the market has a s s i g n e d a low P/E r a t i o i n a n t i c i p a t i o n o f poor earnings r e s u l t s , the s e c u r i t i e s s e l e c t e d had an average compound growth i n e arnings over the f i v e years p r e c e d i n g the s e l e c t i o n year of a t l e a s t 10% per annum. T o t a l p o r t f o l i o r e t u r n was measured as the average percentage p r i c e a p p r e c i a t i o n p l u s percent d i -vidend r e t u r n over each p o r t f o l i o . The p o r t f o l i o s were s e l e c t -ed from the Standard S t a t i s t i c s 1400 Company Annual Compustat p o p u l a t i o n , s u b j e c t to the above p r o v i s i o n r e g a r d i n g earnings growth. A p o r t f o l i o f o r each year was then c o n s t r u c t e d con- . t a i n i n g the ten s e c u r i t i e s which had the lowest P/E r a t i o s i n the e n t i r e h i g h growth r a t e p o p u l a t i o n . T h i s was p o r t f o l i o Number One. P o r t f o l i o Number Two was s i m i l a r l y chosen, except t h a t the ten s e c u r i t i e s had the lowest P/E m u l t i p l e s r e l a t i v e to t h e i r own i n d u s t r i e s . Each p o r t f o l i o was assumed t o be purchased d u r i n g the f i r s t week i n January, h e l d one year, and s o l d the f o l l o w i n g January. The study was conducted over the f o u r t e e n years from 1953 to 1966. The numerical r e s u l t s of the study was t h a t p o r t f o l i o Number One had a mean compound r e t u r n of .375 w h i l e p o r t f o l i o Number Two had a mean r e t u r n o f o n l y .239. These r e s u l t s were not e n t i r e l y c o n c l u s i v e so the author extended the i n v e s t i g -- 66 -a t i o n t o f i f t y s e c u r i t i e s . The r e s u l t s were a mean compound r e -t u r n o f .301 f o r P o r t f o l i o Number One and .263 f o r P o r t f o l i o Number Two, i n d i c a t i n g l e s s c o n c l u s i v e argument t h a n th e f i r s t c a s e. A t h i r d P o r t f o l i o was f i n a l l y c o n s t r u c t e d , w h i c h was a c o m b i n a t i o n of low i n d u s t r y r e l a t i v e s and low market r e l a t i v e s . Ten s e c u r i t i e s were chosen w i t h t h e l o w e s t r a t i o o f company P/E r a t i o t o average i n d u s t r y P/E r a t i o , w h i c h a l s o were among the f i f t y l o w e s t a b s o l u t e P/E r a t i o s . The r e s u l t was an average compound r e t u r n o f .310, v e r y c l o s e t o t h e r e t u r n o f P o r t f o l i o One's y e a r l y r e t u r n . Breen c o n c l u d e s t h a t t h e e v i d e n c e weakly s u p p o r t s t h e h y p o t h e s i s t h a t t h e r e l a t i v e measure o f low P/E m u l t i p l e s i s a comparison based on t h e whole market r a t h e r t h a n on an i n -d u s t r y b a s i s . W h i l e h i s p o p u l a t i o n i s t h e Compustat s t a t i s t i c -a l s e r v i c e , i t c o u l d be a c c e p t e d as r e p r e s e n t a t i v e . He n e v e r -t h e l e s s adds t h a t , he has n o t p r o v e n i n h i s s t u d y t h a t some i n -d u s t r y c l a s s i f i c a t i o n i s n o t u s e f u l . Hence, t h e s e c u r i t y a n a l y s t g e n e r a l l y combines h i s i n t u i t i o n w i t h an e x a m i n a t i o n o f t h e s t o c k s a c t u a l r e c o r d o f P/E r a t i o s i n r e l a t i o n t o t h e market's r e c o r d i n a r r i v i n g a t a P/E r a t i o f o r t h e p a r t i c u l a r s t o c k i n q u e s t i o n . CURRENT OR NORMALIZED EARNINGS One may ask, i f t h e s e c u r i t y a n a l y s t i s a t t e m p t i n g t o a r r i v e a t a m u l t i p l i e r f o r f u t u r e E.P.S. t o v a l u a t e a p a r -t i c u l a r s t o c k , i s he u s i n g c u r r e n t e a r n i n g s and. c u r r e n t p r i c e s f o r t h e p e r i o d c o v e r e d . What he i s i n d e e d s e e k i n g t o e s t a b l i s h - 67 -i s the relationship between present price and expected future earnings. To do t h i s he must introduce a concept known as "Normalized" earnings, defined as the l e v e l of earnings that would p r e v a i l i f earnings were neither c y c l i c a l l y depressed 2 nor c y c l i c a l l y i n f l a t e d . The difference between actual and normalized earnings i s s i g n i f i c a n t conceptually. If actual annual rather than nor-malized earnings are used as a d i v i s o r , P/E r a t i o s can be very high or low, not because the price i s very high or low, but be-cause earnings are c y c l i c a l l y depressed or i n f l a t e d . As a simple i l l u s t r a t i o n we can consult the Dow Jones Industrial Average for the period 1964-65. We see that P/E r a t i o s de-cl i n e d even though prices rose somewhat, the r e s u l t of sub-s t a n t i a l l y higher earnings. Thus P/E r a t i o s based on normal-ized rather than actual earnings are more useful for valuation purposes. A l o g i c a l question now i s , how do we esta b l i s h the proper rel a t i o n s h i p between present price and expected future earnings. The answer i s that a mathematical connection can be established between calculated normal current earnings and expected average future earnings based on an assumed growth rate. Hence we pass from a P/E multiple based on current earnings to one based on future earnings. To i l l u s t r a t e t h i s point, assume (1) that we accept a current m u l t i p l i e r of 15, (2) that we anticipate a growth rate of 3 1/2% per annum, (3) that we use average earnings for the next seven 3 years. (That the earnings average w i l l then be about 115% o the current figure i f the current figure i s taken as normal, or normalized i n order to place i t on the earnings curve). Hence, i f the m u l t i p l i e r chosen for current earnings i s 15 times, the multiple appropriate for expected future earnings i s 15/1.15 which i s 13 times approximately. P/E RATIO AS A MEASURE OF GROWTH We can postulate that d i f f e r e n t P/E r a t i o s may be accorded to d i f f e r e n t stocks on the basis of expected future rates of growth of earnings and dividends. The reasoning here i s that a r i s i n g future earnings stream i s considered to be worth more than a f a l l i n g one. Graham, Dodd and Cottle assert that a P/E "m u l t i p l i e r should advance proportionately as the 4 expected growth rate r i s e s " . Holt argues that "companies with high growth rates of earnings should be valued higher 5 than companies with low growth rates". I t follows from thes statements then, that we would expect stocks with high P/E multiples to experience the greatest growth i n earnings and dividends i n the subsequent periods. Also, we would expect those stocks with the higher multiples to appreciate the most i n the future. In an attempt to validate these two statements, we s h a l l look at two studies made i n thi s area. - 69 -Murphy and Stevenson have presented an emperical analysis of the r e l a t i o n of a future earnings and dividend growth to past P/E r a t i o s . ^ Two groups of tests were made. In the f i r s t group of te s t s , correlations were made between P/E r a t i o s of selected companies i n the period and growth of earnings and dividends of the same companies i n a succeeding period. In the second group of tes t s , companies were grouped into q u i n t i l e s on the basis of P/E ra t i o s i n one period; then average rates of growth of earnings were computed for each q u i n t i l e i n succeeding periods. To provide consistent and comprehensive r e s u l t s , the following was done: A l l companies selected reported on the same f i s c a l year; the tes t period covered 15 years, 1950 to 1964, the P/E r a t i o was compared with growth E.P.S. not only for the next year, but also for the next two years and the next f i v e years; tests were made of each of the ten d i f f e r e n t test periods ending 1956 - 1957 - 1964; i n order to avoid the ef f e c t of a single year on the P/E r a t i o , a second set of tests was made using the average P/E r a t i o over a f i v e year period; and the f i v e year average P/E ra t i o s were compared with growth of earnings and dividends i n the following year, the next two years and the following f i v e years. Also, to compensate for industry e f f e c t s , a l l tests were made by industry and separate tests were made for each of eleven industries, an aggregate of 2 37 companies. F i n a l l y , since^dividend y i e l d may a f f e c t P/E r a t i o s , an additional set of tests was made i n which the e f f e c t of dividend y i e l d was - 70 -h e l d c o n s t a n t . The r e s u l t s o f t h e t e s t s c o r r e l a t i o n s were as f o l l o w s : In 513 t e s t s o r 85% o f the t e s t s , t h e P/E r a t i o was no t s i g n i f i c a n t l y r e l a t e d t o f u t u r e growth o f e a r n i n g s p e r sh a r e . I n 544 t e s t s o f 89% o f t h e t e s t s , r e l a t i v e P/E r a t i o s gave no s i g n i f i c a n t i n d i c a t i o n s o f f u t u r e growth o f d i v i d e n d s per s h a r e . The a u t h o r s c o n c l u d e by t h i s s t a tement "... i f t h e market judges f u t u r e growth t h r o u g h t h e P/E r a t i o i t i s n o t a good judge o f growth". I f t h e i r c o n c l u s i o n s a r e c o r r e c t t h e r e seems t o be l i t t l e wisdom i n the purch a s e o f h i g h m u l t i p l e 7 s t o c k s i n a n t i c i p a t i o n o f e x c e s s i v e growth. A second s t u d y was made on growth i n terms o f t h e a p p r e c i a t i o n o f t h e share p r i c e . I f H o l t s s tatement quoted above i s v a l i d , we s h o u l d see t h e s t o c k s w i t h t h e h i g h e s t P/E m u l t i p l e s a p p r e c i a t i n g the most. We s h a l l l o o k a t t h e e m p e r i c -a l e v i d e n c e p r e s e n t e d by S. F r a n c i s N i c h o l s o n t o shed some l i g h t g on t h i s q u e s t i o n . N i c h o l s o n c o nducted two s t u d i e s . The f i r s t s t u d y c o v e r e d 100 p r e d o m i n a n t l y i n d u s t r i a l i s s u e s o f t r u s t i n v e s t -ment q u a l i t y and i n c l u d i n g many o f t h e l a r g e s t companies. Four r a i l r o a d s t o c k s were i n c l u d e d , b u t no u t i l i t i e s , b anks, f i n a n c e o r i n s u r a n c e s t o c k s . P r i c e s and P/E r a t i o s were a s c e r t a i n e d f o r each s t o c k f o r 1939, 1944, 1949, 1954 and 1959. A l s o , t h e p e r c e n t a g e o f p r i c e a p p r e c i a t i o n was computed f o r each o f t h e s e d a t e s t o subsequent d a t e s i n the f u t u r e as f o l l o w s : 5 y e a r p e r i o d s from 1939 - 1959; 10 y e a r p e r i o d s from 1939 -- 71 -1949, 1944 - 1954, 1949 - 1959; 15'year periods from 1939 -1954, 1944 - 1959; and twenty year periods from 1939 - 1959 and the two year period 1957 1959. The second study covered 29 chemical stocks with prices and P/E r a t i o s for years 1937 - 1954, i n c l u s i v e , except that data for seven of these companies was not available for a l l of the 18 years i n t h i s period. The percentage of price appreciation was computed as follows for each stock: 3 year periods from 1937 - 1954; 6 year periods from 1937 -1950 and 10 year periods from 1937 - 1947. While the author makes a large number of observations on his findings, the hypothesis that average stocks with low P/E multiples experience greater appreciation than stocks with high P/E multiples. Nicholson suggests that high P/E multiples t y p i c a l l y r e f l e c t investor s a t i s f a c t i o n with companies of high q u a l i t y , or those which have experienced several years expan-sion and r i s i n g earnings. In such cases prices often w i l l r i s e faster than earnings, and i t often runs to extremes. When th i s happens, upward price trends are eventually subject to slow down or reversal. High multiple stocks then develop trends which on the average compare unfavourably with low multiple stocks which have not yet been bid up to vulnerable price l e v e l s . The emperical evidence we have seen here suggests that the P/E r a t i o of a stock i s not s i g n i f i c a n t l y correlated to subsequent earnings or dividends. In other words, the P/E i s a poor judge of future growth. Also, stocks with high P/E multiples appear to experience less price appreciation than stocks with low P/E multiples. Some growth stocks nevertheless have been exceptions to these findings and for temporary periods at l e a s t , have continued to appreciate i n p r i c e . These ex-ceptions explain why many investors do not regard high P/E r a t i o s as dangerous but as evidence of future growth p o t e n t i a l and of further price appreciation to be expected. The results of these two studies, do cast doubts on the v a l i d i t y of these b e l i e f s . In 196 3 the distinguished investment banking firm 9 Drexel & Co. of Philadelphia, applied the P/E r a t i o c r i t e r i o n to the highest and lowest multiple stocks within the DJIA. They divided the DJIA into three categories, the lowest, the middle and the highest P/E r a t i o stocks. This study showed that i f a hypothetical investor invested $10,000 i n June 1936 i n the highest P/E r a t i o stocks and annually reinvested i n the 10 highest multiple stocks each year, his investment would have grown to $25,347 by June 1962. While an investment i n the middle category would have grown to $4 3,672 and the i n -vestment i n the lowest P/E r a t i o category would have yielded $66,866 during the same time span. It i s of i n t e r e s t to note that the annual compound rate of return on the three categories approximate 3.5%, 5.7% and 7.5% respectively. Another s i g n i f i c a n t study has been done by J.D. McWilliams.^ McWilliams selected his sample companies from the S&P's 900 - i n d u s t r i a l company Compustat tape - according to three c r i t e r i a . F i r s t a complete 12 year history of A p r i l prices from 195 3 - 1964 must be available on each company. Secondly, only l i s t e d companies are e l i g i b l e . Hence 390 com-panies were selected. The P/E r a t i o s were calculated by d i v i d i n g A p r i l 30th prices by earnings per share for the year ending p r i o r to December 31st. After determining the P/E r a t i o s of the 390 stocks i n the sample, the data was rearranged into d e c i l e s . Decile #1 included the lowest P/E r a t i o stocks available each year while #10 includes that of the highest multiple stocks. The results show that an hypothetical $10,000 invested and con-t i n u a l l y reinvested on an annual basis i n the highest d e c i l e stocks would have appreciated to $45,329 by A p r i l 30, 1964, while the same investment i n the lowest P/E category would have grown to $10 3,960; the average DJIA stock would have grown to $50,2 36. Generally these studies show that better investment performance can be obtained from a p o r t f o l i o comprised of low P/E r a t i o stocks as contracted to p o r t f o l i o s made up of high P/E r a t i o stocks. However, for i n d i v i d u a l s e c u r i t i e s good per-formance may be found among stocks s e l l i n g at any P/E r a t i o , though the poorest performers are most frequently found among those stocks s e l l i n g at large premiums r e l a t i v e to earnings. 12 Commenting on these studies Maldovsky observed that there are two procedures that would have i n f l e c t e d serious bias i n the results of S.F. Nicholson and J.D. McWilliams. F i r s t , the sample stocks were not selected on a random basis. The Nicholson studies selected q u a l i t y stocks from the vantage point of 1960 instead of employing the standards of 1939. The - 74 -entire range of equities whether l i s t e d or unlisted has not been included i n any of the studies. (Actually the selection used better serves our present study). Secondly, Maldovsky i s concerned with the periods cu-mulative reinvestment into high and low P/E stocks. This prac-t i c e would necessarily magnify any overpricing or underpricing i n the s p e c i f i c group. He observed that stocks with high mul-t i p l e s are more f r a g i l e and vulnerable than those with low P/E r a t i o s . Only expectations of future earnings growth at a high compound rate w i l l support t h e i r p r i c e s . High P/E r a t i o stocks would suffer substantially from unrealized growth expectations, while the more moderate expectations of low P/E stocks may turn out some pleasant surprises. Hence, investments i n high P/E stocks w i l l become i n -creasingly vulnerable to a price setback af t e r each successive reinvestment and subsequently "Penalized". The group with the lowest P/E r a t i o i s growing i n strength a l l the time, since the earnings base i s being en-larged at the time of reinvestment and equities whose earnings have demonstrated stronger action than t h e i r respective prices are being bought continuously. This group would be rewarded i n respect to appreciation. These remarks i n fact tend to re-inforce the views of S.F. Nicholson, Breen and t h e i r i l k . 13 Paul F. M i l l e r asserted that i n his research, the high P/E stocks tend to have better earnings growth over a period of time than do low P/E stocks. This observation i s obvious since a high P/E r a t i o implies a r e l a t i v e l y low - 75 -earnings base. However i t i s i n t e r e s t i n g to consider his f i n d -ings i n quantitative terms where M i l l e r states that about 65% of the issues i n high P/E categories would have superior trends while 65% of the stocks i n low P/E categories show declining earnings trends. However the balance of 35% of the respective group makes the difference i n performance. The 35% i n the low P/E r a t i o group turns out to have very good earnings trends while the opposite 35% prove to be disappointments, recording substantial losses. Before any conclusion can be drawn to affirm the superiority of low P/E ra t i o s over high P/E r a t i o s s e c u r i t i e s , we must use the P/E r a t i o s to determine whether a stock i s under/overpriced with respect to the industry and even the popular indicese. (This the trained analyst recognizes as the Relative Value Technique). If the stock i s underpriced and has a low P/E r a t i o , then i t represents an a t t r a c t i v e buy. However, stocks may have a low P/E multiple because the market as a whole anticipates poor earnings performance by a company. In th i s case the low P/E r a t i o i s j u s t i f i e d and the stock i s not underpriced. VALUATION OF STOCKS USING P/E RATIOS We have seen that the P/E r a t i o has been i n c o r r e c t l y used for valuation purposes i n a number of ways. Now l e t us look at some of the advances that have been made in the use of the P/E r a t i o s . 14 Cohen and Zineberg have suggested that P/E r a t i o s - 76 -may be a reasonable alternate to the present value analysis i n evaluating s e c u r i t i e s . The concept of present value of future dividends to in d i v i d u a l stock valuation requires many assumptions about de-velopments i n the distant future and any r e s u l t would tend to have a large margin of error. The P/E r a t i o approach may be more pragmatic. Before a r r i v i n g at a proper P/E r a t i o for stocks we should f i r s t determine the P/E for the market and as was mentioned previously differences of P/E r a t i o s r e f l e c t d i f -ferent industry and company c h a r a c t e r i s t i c s including intan-gible factors l i k e the quality of management and prospects of the industry. The results of a multiple regression analysis i n d i c -ates that a company's P/E r a t i o has tended to be higher or lower than that of the averages under the following conditions: (a) P/E r a t i o i s about one point higher than the average for every 1% by which a company's expected 5 year growth of earnings power exceeds the corresponding expected growth of the averages. (b) P/E i s about 3/4 of a point higher for every 10% by which a company's normal dividend payout exceeds the payout r a t i o of the averages. (c) The P/E r a t i o i s one to two points higher i f a company's sales s t a b i l i t y i s subs t a n t i a l l y higher than the averages. (d) P/E r a t i o s seem to r i s e i f a large number of finan-- 77 -- c i a l i n s t i t u t i o n s own the stock, (e) P/E r a t i o s tend t o vary i n v e r s e l y w i t h f i n a n c i a l l e v e r a g e , a l l other t h i n g s being h e l d c o n s t a n t . A study which may i n d i c a t e how the P/E r a t i o w i l l be used i s d i s c u s s e d by Whitbeck and K i s o r ^ i n t h e i r a r t i c l e A New T o o l i n Investment D e c i s i o n Making. T h i s study i s based on 135 stocks o f g e n e r a l investment i n t e r e s t and regarded t h i s as the g e n e r a l market. Using a l e a s t - squares method, they a r r i v e d a t a market P/E r a t i o based on normalized e a r n i n g s , the average P/E r a t i o a t t a c h e d t o each l e v e l of p r o j e c t e d growth i n ea r n i n g s , the r e l a t i o n s h i p between s t a b i l i t y o f earnings and the market P/E r a t i o and the average r e l a t i o n s h i p between the market P/E r a t i o and d i v i d e n d payout. The r e l a t i o n s h i p was p o s i t i v e . Then u s i n g m u l t i p l e r e g r e s s i o n a n a l y s i s they d e r i v e d an equation f o r a " t h e o r e t i c a l P/E r a t i o " , based on the sample of 135 stocks a l l p r i c e as at June 8, 1962 c l o s i n g p r i c e s . The T h e o r e t i c a l P/E r a t i o = 8.2+1.5 {growth r a t e ) + 6.7 (payout) - 0.2 (standard d e v i a t i o n ) . The f i r s t component i s a constant term and i t i s to t h i s base m u l t i p l e t h a t we add t o , or s u b t r a c t from, the e f f e c t s o f the v a l u a t i o n f a c t o r s - the p r o s p e c t i v e growth, s t a b i l i t y and payout of e a r n i n g s . Using a company's p r o j e c t e d growth r a t e , d i v i d e n d payout and i t s s t a n -dard d e v i a t i o n we can compute a company's T h e o r e t i c a l P/E r a t i o . I t i s important t o note t h a t the T h e o r e t i c a l P/E r a t i o i s determined on the b a s i s o f a s i n g l e s t a t i c moment, and we would expect the average relationships to change from day to day. The crux of the authors t h e o r e t i c a l or normal price of any stock, we assume that the market price of the stock w i l l seek t h i s l e v e l faster than the t h e o r e t i c a l price i t s e l f w i l l change - th i s i s the kay to our analysis. In order to test t h e i r theory, the authors chose to compare the Theoretical P/E r a t i o to the actual P/E r a t i o as a judge of over or under valuation. They say that the valuation study i s successful whenever the under value stocks i n r e l a t i o n to the general market outperforms Standard and Poors 500 -Stock Index and vice versa. The undervalued group consists of those stocks with price ratios - r a t i o s of market price to t h e o r e t i c a l price - of less than .85 while the overvalued group contains issues with price r a t i o s of 1.15 or greater. The study shows that i n each of the 3 month periods following the price dates, the undervalued group had a mean performance superior to that of Standard and Poors 500 and the 500 consistently outperformed those stocks labeled as over-valued i n r e l a t i o n to the market as a whole. The cumulative appreciation percentages were for 12 months -Undervalued Group + 38.9% S&P's 500 23.8% Overvalued Group 15.3% It i s due to studies such as that c i t e d above that increasing-l y investment analysts are moving away from simply observing - 79 -and averaging past P/E r a t i o s i n t r y i n g to decide the value of a p a r t i c u l a r stock. Some i n s t i t u t i o n s are applying the tech-nique of multiple regression as well as other s t a t i s t i c a l tech-niques i n f i n a n c i a l analysis. This i s undoubtedly the d i r e c t i o n of the future. CONCLUSION Three s i g n i f i c a n t s t a t i s t i c a l studies have shown low P/E r a t i o s e c u r i t i e s have consistently outperformed the high P/E r a t i o stocks, though there are inadequacies as to choice of sample and the cumulative reinvestment method. The outcome of these studies j u s t i f i e s the existence of underpriced stocks with great growth po t e n t i a l overlooked by the market. The school of thought that a high P/E multiple i s an indicat i o n of growth has proven only that the high P/E r a t i o i s a poor judge of growth. The P/E evaluation method can be used to determine whether the low P/E r a t i o i s j u s t i f i e d i n a n t i c i p a t i o n of a poor future earnings trend, or undervalued by being overlooked i n the market. High P/E r a t i o stocks often represent prices which investors bid too sharply i n r e l a t i o n to actual growth and the i n f l a t e d portion of the price does not j u s t i f y the pur-chase of very high P/E r a t i o stocks. This leads us to favour the purchase of low P/E - 80 -s ecur i t i e s which meet ce r t a in c r i t e r i a , i n c l u d i n g : a cons i s tent ly high earnings record i n past years , that there i s evidence that earnings w i l l not dec l ine i n future years the q u a l i t y of management i s high with f i n a n c i a l s t a b i l i t y a r e l a t i v e l y high margin and turnover. CHAPTER VII INDEX TO FOOTNOTES Will iam Breen, Low Price-Earnings Ratios and  Industry Relatives, F i n a n c i a l Analysts Journal, New York, N.Y., July-August, 1968, pp. 125-127. Cohen & Zinborg, Investment Analysis and 'Po r t f o l i o Management, Richard D. Irwin, Inc., 1967, Homewood, I l l i n o i s , p. 240. Graham, Dodd & Cott l e , Security Analysis, P r i n c i p l e s and Techniques, McGraw-Hill Book Co. Inc., 1962, New York, N.Y., p. 509. Ibid., p. 537. C.C. Holt, The Influence of Growth Duration  on Share Prices, The Journal of Finance, Vol. XVII, No. 3, September, 1962. Murphy & Stephenson, Price/Earnings Ratios  and Future Growth of Earnings and Di-vidends , F i n a n c i a l Analysts Journal, November-December, 1967, pp. 111-114. Ibid., p. l l 4 . S.F. Nicholson, Price-Earnings Ratios i n Book by E.M. Lerner, Readings i n F i -nancial Analysis and Investment Manage- ment , Richard D. Irwin, Inc., 1963, Homewood, I l l i n o i s , pp. 300-304. Nicholas Molodovsky, "Recent Studies of P/E Ratios", Financial Analysts Journal, May-June, 1967, pp. 102-103. Dow Jones Industrial Average: c i t . , Cohen & Zinberg, Op. c i t . , p. 763. James D. McWilliams, "Prices, Earnings and P/E Ratios", F i n a n c i a l Analysts Journal, May-June, 1966, p. 137. continued: Page 2 Molodovsky, op. c i t . , p. 104. Paul F. M i l l e r , Molodovsky, op. c i t . , pp. 107-108. Cohen & Zinberg, op. c i t . , pp. 246-248. Whitbeck & Kisor, A New Tool i n Investment  Decision-Ma king, In Book by E.B. Frederickson, Frontiers of Investment  Analysis, International Textbook Company, 1966, Scranton, Pennsylvania, pp. 335-350. CHAPTER VIII THE QUESTIONNAIRE, RESULTS AND FINDINGS THE QUESTIONNAIRE In order to determine to what extent the Price Earn-ings Ratio influences the p o r t f o l i o manager's decisions i n the purchase of equities for pension funds i n Canada, i t i s essen-t i a l that we c a l l upon the investment managers themselves for th i s information. This poses a special kind of problem since most investment managers are reluctant to discuss t h e i r tech-niques for p o r t f o l i o s e l e c t i o n . Despite the d i f f i c u l t i e s that may be encountered i t was decided to approach each investment manager d i r e c t l y and ask him to complete a questionnaire, a copy of which i s shown as Annex 8.A to t h i s chapter. This questionnaire was sent out to f i v e n ationally based t r u s t com-panies and two Vancouver based firms dealing i n pension funds. THE SCOPE OF THE QUESTIONNAIRE It was recognized that the price-earnings r a t i o i s rar e l y considered i n i s o l a t i o n when an investment manager con-siders a p a r t i c u l a r stock on a buy or s e l l basis. Therefore, i t was decided to glean as much informtion as possible from the investment manager with regard to his investment pro-cedures . The questionnaire was designed to determine to what extent the p o r t f o l i o manager considered: a. Technical and Fundamental analysis and those elements contributing to each '-type of analysis. - 82 -Technical Analysis Here we wished to determine to what extent the man-ager considered the various technical indices and the actual role they play i n his decisions. Fundamental Analysis In t h i s instance we want to determine the extent to which the investment manager considered General Ec-onomic conditions, the Interpretation of Fi n a n c i a l Statements and the price to earnings r a t i o . b. The Price to Earnings Ratio with emphasis on the following: Does he consider buying high P/ER equities or low P/ER equities i f indeed he considers the P/ER at a l l . Does he consider equities with a P/ER lower than that of the popular indicese to be under p r i c e ; to be purchased or to be avoided? Conversely, does he consider equities with a P/ER higher than that of the popular indicese to be over-priced; to be purchased or avoided? - When looking for c a p i t a l gain, does he select the high or low:.'multiple equities? c. E f f i c i e n t P o r t f o l i o Models such as those developed by Professor Harry Markowitz Does the investment manager attempt to develop an e f f i c i e n t p o r t f o l i o set by the use of s t a t i s t i c a l analysis. - 83 -Does he consider p r o b a b i l i t y theory as such, when selec t i n g stocks for a pension p o r t f o l i o . d. Does the investment manager consider Relative Value Techniques when selecting a stock for a p o r t f o l i o since t h i s i s a l o g i c a l development from consider-ation of the price-earnings r a t i o . e. The services and counselling of the various invest-ment brokers; that i s , does he make use of the services? The investment manager was then i n v i t e d to o f f e r any other comments he may have to shed more l i g h t on the consider-ations that go into investment i n Canadian Pension Funds. The Findings In the findings, each questionnaire w i l l be summar-ized showing how the investment manager for each pension fund uses the various fundamental and technical tools for analysis as well as the outside counselling and information services. Company A The investment manager only occasionally used tech-n i c a l analysis and i n doing so only occasionally used the Volume Index, the Breadth Index and the Short Position Index. It was further stated that the following indicese were never used, the Dow Theory, the High Low Index, the Odd Lot Index, the Confidence Index nor charting. This investment manager always used Fundamental Analysis and i n doing so always considered General Economic Conditions, usually analysed F i n a n c i a l Statements and usually - 84 -c o n s i d e r e d the P r i c e - E a r n i n g s r a t i o . He a l s o c o n s i d e r e d the p r o j e c t e d growth r a t e of earnings per share which i s i n f a c t a v a r i a t i o n of the P r i c e Earnings r a t i o . In c o n s i d e r i n g the p r i c e earnings r a t i o f o r investment d e c i s i o n s , t h i s f i r m used the P/ER to a c o n s i d e r a b l e e x t e n t f o r purchases, to a l e s s e r e x t e n t f o r s a l e s . A h i g h P/ER was sometimes c o n s i d e r e d as an i n d i c a t i o n of a growth stock t o be purchased p r i m a r i l y f o r c a p i t a l g a i n . However, he p o i n t e d out t h a t i n h i s o p i n i o n , growth stoc k s have a h i g h p r i c e v o l a t i l i t y t h a t can o f f s e t the value of i t s earn-ings growth r a t e . Here i t i s presumed t h a t t i m i n g would be most important. As a r e s u l t , a h i g h P/ER d i d not i n d i c a t e the stock was o v e r p r i c e d and should be s o l d . A low P/ER was c o n s i d e r e d u n d e r p r i c e d and should be purchased f o r income but p o i n t e d out t h a t a low P/ER u s u a l l y denotes a h i g h degree of c y c l i c a l i t y and t h a t a low P/ER o f f e r s c a p i t a l g a i n i f the b u s i n e s s c y c l e i s moving up. A low P/ER was not n e c e s s a r i l y u n d e s i r a b l e and i n d i c -a t i v e of a poor or stagnant s i t u a t i o n and c o n s i d e r e d t h a t each stock must be judged on i t s own m e r i t . The P/ER of a stock was c o n s i d e r e d i n r e l a t i o n t o the popular i n d i c e s e when d e c i d i n g whether the P/ER was h i g h or low. The investment manager t r i e d t o g i v e the impression t h a t he f o l l o w e d the model o f Markowitz f o r p o r t f o l i o s e l e c t i o n . In r e a l i t y the r i s k a s s o c i a t e d w i t h i n d i v i d u a l s e c u r i t i e s was c o n s i d e r e d but not i n the sense o f r e t u r n s being random - 85 -v a r i a b l e s , and the c o v a r i a n c e between any two s e c u r i t i e s being d e r i v e d and known. T h i s investment manager s t a t e d t h a t the R e l a t i v e Value Technique was u s u a l l y used but the p r e c e d i n g answers s t r o n g l y h i n t e d t h a t i t was not. T h i s f i r m makes e x t e n s i v e use o f i n f o r m a t i o n o f f e r e d by v a r i o u s brokerage f i r m s . OTHER COMMENTS "Each i n s t i t u t i o n approaches the broad s u b j e c t of i n -vestment management of pension funds i n d i f f e r e n t ways though a l l l a r g e i n s t i t u t i o n s have t o some extent the same problem i n t h a t they are v i r t u a l l y unable, due to t h e i r s i z e , t o be t o t a l -l y l i q u i d a t any one time. The sheer magnitude o f a program to s e l l e q u i t i e s i n a f a l l i n g market would c e r t a i n l y h e l p to push t h a t market down f a s t e r and f u r t h e r . The mutual funds have had to w r e s t l e w i t h t h i s problem f o r some time, w h i l e pension funds are more f o r t u n a t e i n t h a t they have a p o s i t i v e cash flow 1! The investment manager was p u z z l e d by the emphasis being p l a c e d on t e c h n i c a l a n a l y s i s as a d e c i s i o n making a i d s i n c e t e c h n i c a l a n a l y s i s by i t s nature i s h i s t o r i c - i t t e l l s what has happened. Investment d e c i s i o n s are based on an a t -tempt to determine what w i l l happen. Th i s investment manager p o i n t e d out t h a t at the market bottom i n May 1970, a l l t e c h n i c a l i n d i c a t o r s p o i n t e d down. Today a f t e r over a 40% r i s e i n the Dow Jones averages - 86 -a l l technical indicators point upwards. In considering r i s k return models he states that they are both useful and in t e r e s t i n g but once again measure the r i s k that has been taken. Further, he understands that the text book version of the stock market indicates i t to be a r e l a t i v e -ly perfect market which moves i n a l o g i c a l fashion based upon s t a t i s t i c a l analysis and a number of s c i e n t i f i c inputs. In r e a l i t y he states that the stock market and a l l c a p i t a l markets from time to time are far from perfect and judgment emerges as the key determinant i n r e l a t i v e l y successful performance. Company B The investment manager of thi s Trust Company based a l l his decisions on the fundamental concept and stated quite c a t e g o r i c a l l y that they do not consider any of the technical indicese. This included charting. When considering the Fundamental analysis concept they attached great importance to the analysis of general ec-onomic conditions and then consider the s p e c i f i c industry de-velopments. Industry developments took p r i o r i t y over the analysis of a p a r t i c u l a r company's f i n a n c i a l statements. The investment manager stated that "the P/ER i s re-levant to determining return pozential for a s p e c i f i c common stock and since his selection of stock i s based on future re-turn and future r i s k , the present P/ER i s an important influence in t h i s decision. A low or high P/ER means nothing i n i t s e l f according to t h i s investment manager i n so f a r as i t was onl y p a r t o f an equation t h a t determines f u t u r e r e t u r n . In the w r i t e r ' s view a low or h i g h P/ER should mean a g r e a t d e a l i f as t h i s i n v e s t -ment manager says t h a t " i t forms p a r t of an equation t h a t de-termines f u t u r e r e t u r n " . The P/ER was compared g e n e r a l l y w i t h the P/ERs of the popular i n d i c e s e i n what the investment manager s a i d was i n order t o determine i t s v a l i d i t y , but s e l e c t i o n was not simply a f u n c t i o n of whether i t was above or below these averages. The investment manager d i d use p r o b a b i l i t y models i n a s s e s s i n g a t t r a c t i v e n e s s o f s e c t o r s w i t h i n the e q u i t y market and t o determine a range of f u t u r e r e t u r n f o r a s p e c i f i c stock. A p parently no attempt was made t o d e r i v e a s e t of e f f i c i e n t p o r t f o l i o s i n the "Markowitzian" manner. The investment manager does not use the R e l a t i v e Value Technique. OTHER COMMENTS The investment manager s t a t e d t h a t t h i s company had an i n t e r n a l investment r e s e a r c h group t h a t c o n c e n t r a t e s on fundamental a n a l y s i s f o r s p e c i f i c s e c u r i t i e s and they d e a l o n l y i n s e c u r i t i e s where p e r s o n a l c o n t a c t with management was p o s s i b l e . The investment manager d i d make e x t e n s i v e use o f a number of investment d e a l e r s both i n Canada and the U.S.A. but any investment made must be preceded w i t h an indepth study by one of h i s own a n a l y s t s . - 88 -The c r i t e r i a for selection are the following: 1. Consideration of proven and current a l e r t management c a p a b i l i t i e s as a p r i o r i t y . 2. Consideration of companies having above average earn-ings p o t e n t i a l over two to three years with emphasis on reasonable P/E multiples at time of purchase. 3. Consideration of emphasis also into industries of above average growth r e l a t i v e to a constantly changing economy. Company C This investment manager used both Technical analysis and Fundamental analysis but q u a l i f i e d his answer i n t h i s manner. He usually applies technical analysis i n his decision making process but weights his decision by 10%. He always bases his investment decisions on Fundam-ental analysis and weights his decision by 90%. The only technical index he uses i s the volume index but he usually uses charting i n reaching his decisions. Regarding decisions based on Fundamental Analysis he always considers General Economic conditions with, as he says, a 50% weighting. Further, he always considers the analysis of f i n a n c i a l statements but places a lesser weighting on them. He usually considers the Price Earnings Ratio but places a lesser weighting on i t than on the analysis of f i n -a n c i a l statements. He usually considers the dividend y i e l d - 89 -when making d e c i s i o n s . The p r i c e earnings r a t i o of a common stock i n f l u e n c e d h i s investment d e c i s i o n s as he s t a t e s "on a r e l a t i v e b a s i s i n terms of g e n e r a l economic c o n d i t i o n s " . When c o n s i d e r i n g a h i g h P/ER he never t h i n k s of i t as d e s i r a b l e , but f e e l s i t may be an i n d i c a t i o n of above average growth p r o s p e c t s . A h i g h P/ER i s c o n s i d e r e d an i n d i c a t i o n of an over-p r i c e d stock o n l y when compared r e l a t i v e t o other stocks i n the i n d u s t r y . A low P/ER i s c o n s i d e r e d d e s i r a b l e o n l y when the d i -vidend y i e l d i s taken i n t o c o n s i d e r a t i o n . In keeping with 7:,his p r e v i o u s statement, t h i s i n v e s t -ment manager c o n s i d e r s the P/ER of a stock r e l a t i v e t o the P/ER of the popular i n d i c e s e . With r e s p e c t to p o r t f o l i o s e l e c t i o n models such as those of Markowitz and o t h e r s , the investment manager never c o n s i d e r e d nor made use of them. T h i s investment manager made much use o f the R e l a t i v e Value Technique. T h i s was c o n s i s t e n t with h i s answers through-out the q u e s t i o n n a i r e . OTHER COMMENTS T h i s f i r m p l a c e s a h i g h value on the use o f e l e c t r o n -i c computers and t h e i r a p p l i c a t i o n i n the investment r e s e a r c h and management f i e l d s and o f t e n makes r e f e r e n c e to the models of Harry Markowitz. The Research Department has i t s own s t a f f - 90 -of experts who make regular use of the firms extensive computer f a c i l i t i e s and carry out special projects at the computer centre at McGill University. This firm joined a group of t h i r t y major U.S. f i n a n c i a l firms sponsoring the "Institute for Quantitative Research i n Finance at Princeton University and i s the only Canadian partici p a n t " . This firm i s one of 10 charter members of a centre for F i n a n c i a l Research at McGill University. The centre has available to i t s members a data bank of key information of 900 U.S. and 500 Canadian companies. It i s expected that the data bank w i l l ultimately include, a l l h i s t o r i c and current economic and f i n a n c i a l informtion of value to f i n a n c i a l analysts. The firm feels that t h i s w i l l be a major step forward i n harnessing the computer to investment analysis multiplying manifold the scope of investment research available to aid p o r t f o l i o manage-ment. Not a l l this firms analysts are sold on t h i s idea and strongly adhere to the G.I.G.O. p r i n c i p l e . Company D Investment decisions for common stocks are made p r i -marily on fundamental analysis of the economy, industry and the p a r t i c u l a r company under examination. Technical analysis i s used only i n an attempt to improve the f i n a l purchase or sale price and only a f t e r an investment decision has been made on a fundamental basis, what technical analysis used i s con-fined to charting. Based on the premise that an i n d i v i d u a l firm has a - 91 -b e t t e r p o t e n t i a l f o r earnings growth i n a fa v o u r a b l e e n v i r o n -ment, the g e n e r a l economic c o n d i t i o n s and the f a c t o r s a f f e c t i n g the supply and demand f o r the product p l a y a very important p a r t i n a r r i v i n g a t an investment d e c i s i o n . As t o a s s e s s i n g the i n d i v i d u a l company, the a n a l y s i s o f f i n a n c i a l statements i s used t o s e l e c t the most pro m i s i n g company w i t h i n an i n d u s t r y ( r e t u r n on e q u i t y , leverage f a c t o r s , and the q u a l i t y o f e a r n i n g s ) . With the i n c l u s i o n of fundamental a n a l y s i s , t h i s company a l s o attempts to make a s u b j e c t i v e assessment on the management of the company. The investment manager does not n e c e s s a r i l y c o n s i d e r a h i g h P/ER as d e s i r a b l e and an i n d i c a t i o n of growth. Given such a s i t u a t i o n the market p l a c e has assessed such a s e c u r i t y as a growth company. I t i s necessary to assess whether f u t u r e growth can be maintained a t the same l e v e l i n a r r i v i n g at an investment d e c i s i o n o f growth. Hence t h i s investment manager does not c o n s i d e r a hig h e r P/ER as an i n d i c a t i o n o f an o v e r p r i c e d stock nor does he c o n s i d e r a low P/ER stock as u n d e r p r i c e d but i f the fundam-e n t a l a n a l y s i s assessment i s f a v o u r a b l e i t c o u l d be purchased f o r c a p i t a l g a i n . The a n a l y s t does not c o n s i d e r the P/ER of a stock r e -l a t i v e t o the P/ER of the popular i n d i c e s e but does use the P/ER o f a p a r t i c u l a r stock r e l a t i v e t o s e c u r i t i e s w i t h i n the i n d u s t r y . No use i s made of such models as those o f Markowitz. - 92 -This investment manager points out that whereas there i s no use made of counselling firms as such, he does use the work of various investment brokers which are screened by his own analysts and used only to the extent i f they meet his i n -vestment requirements. OTHER COMMENTS For the most part information about companies and general economic conditions comes from two sources. F i r s t , the firm's analysts work closely with s p e c i a l i s t analysts i n the investment community. Their information i s usually re-ceived i n the form of reports, summaries and related data which cover the broad spectrum of the Canadian and American economies. They assess and evaluate t h e i r work. They also have connections with Bankers Trust Company and Morgan Guaranty Trust i n New York and use that aspect of t h e i r American stock selection extensively. Secondly, analysts make f i e l d t r i p s for discussions with the management of a number of companies i n which they have an investment int e r e s t . Further, they re t a i n an outside economic consultant who provides a quarterly review of trends and developments within the Canadian and American economies. These reports are studied by senior personnel and are r e f l e c t -ed i n the firms general investment p o l i c y . The p r i n c i p a l objective of the firm i s maximization of the return on the fund without incurring an undue amount of r i s k . - 93 -Company E This firm seldom uses technical analysis on which to base t h e i r investment decisions. The investment manager usually uses fundamental analysis. When considering technical analysis t h i s manager follows some of the charts prepared by leading brokerage firms. Any orders entered or decisions made on technical analysis w i l l normally be through a recommendation made by one of these broker-age firms together with his own fundamental assessment. When the investment manager i s considering decisions based primarily on fundamental analysis, General Economic Con-ditio n s are weighed to make a decision on whether to add to or reduce equities generally or stress an area i n the fixed i n -come sector. In considering the general economic conditions t h i s manager attempts to segregate favourable and unfavourable economic sectors. Only moderate consideration i s given to the analysis of f i n a n c i a l statements and uses the P/ER only as a comparison with other companies i n the industry. The P/ER of a common stock has l i t t l e influence on t h e i r investment decisions but the investment manager usually avoids holding stocks with a P/ER greater than 30. In t h e i r opinion a high P/ER does not necessarily i n -dicate a good growth stock or that past growth w i l l continue or accelerate. However, they f e e l that stocks with good growth rates and future prospects may carry a high P/ER that i s j u s t i f i e d by quality and marketing p o t e n t i a l and could therefore - 94 -be purchased with the prime objective over the medium term being c a p i t a l gain. A high P/ER i s not always considered an i n d i c a t i o n of an overpriced stock. A low P/ER may indicate an undervalued s i t u a t i o n i n the present economic climate and a f t e r further investigation could be purchased for either income or c a p i t a l gain. Occasionally a low P/ER indicates to t h i s investment manager a poor or stagnant s i t u a t i o n but only occasionally does the investment manager consider the P/ER of a stock r e l a t i v e to the P/ER of the popular indicese. Such models as those of Markowitz are never followed. The Relative Value Technique i s seldom used. This firm uses brokers fundamental and technical re-search to a great extent along with various investment services and co-ordinates outside recommendations with t h e i r own economic outlook to design a p o r t f o l i o to meet an accounts p a r t i c u l a r objectives. Pooled p o r t f o l i o s are managed at the head o f f i c e . The l o c a l o f f i c e r s determine the accounts objectives and d i r e c t cash flows to s p e c i f i c funds, eq u i t i e s , fixed income and mort-gages, to obtain the desired return and p o r t f o l i o d i v e r s i f i c -ation . OTHER COMMENTS The Assistant General Manager points out that t h e i r pooled pension fund i s quite large and has " b u i l t i n " management - 95 -problems. Large funds cannot be swung and the fund managers a b i l i t y to move positions around i s limited to but a portion of the assets. Nonetheless, p o r t f o l i o objectives are to consis-tently do a l i t t l e betterpperhaps 2 or 3% better, than the market. A pension fund with much greater ambition i s not l i k e l y to be well served. He further states that investment management i s an a r t , not a science, and therefore cannot be too precise. OUTSIDE COUNSELLING FIRMS Since 1968, i n house research has been supplanted by a greater orientation towards outside work provided by broker-age houses and independent research firms. In 1970 a research evaluation program was e s t a b l i s h -ed with p a r t i c i p a t i o n from over s i x t y brokerage firms i n Canada and the U.S.A. This adjunct to t h e i r operations, using a series of programs developed by Watnik & Co. i n New York, at-tempts to cut through basic attitudes to esta b l i s h a r e a l basis of performance through selection, timing, and stock emphasis and also to set a basis of understanding for r i s k exposure with tolerable l i m i t s . The program attempts to determine how t h e i r i n t e r n a l research and p o r t f o l i o management s t a f f can most productively allocate t h e i r e f f o r t s and energies to the most useful sources of information. The firm does not consider a charting as a means of determing market decisions. It was however noted that one of the investment managers did accept charting but not to any great extent. Fundamental Analysis This firm attempts to move from the general to the s p e c i f i c , and when considering Fundamental analysis moves from General Economic Conditions to the i n d i v i d u a l company within the industry. Two main points of i n d i v i d u a l companies are research-ed thoroughly - sales growth and earnings growth - comparisons are made against both i n d u s t r i a l averages and i n d i v i d u a l company attainment. A company's past record may not be i n d i c a t i v e of i t s capacity to cope with the future, hence an assessment i s made of management. This they f e e l i s p a r t i c u l a r l y important i n r e l a t i o n to smaller companies i n Canada, and with e s t a b l i s h -ed companies, the assessment i s often more important than s t a t -i s t i c a l records. The Price Earnings Ratio This firm prefers to purchase stocks with a low P/ER but they do not believe that low P/ER stocks are necessarily underpriced. In some instances, they f e e l , a low P/ER may i n -dicate that there i s something wrong with the company or with the industry i n which i t operates. This firm follows the p r i n c i p l e of the Relative Value Technique. Company F This investment manager uses Fundamental analysis to select common stocks, while technical analysis i s used i n timing the purchase or sale. He feels that Fundamental analysis has an 80% weight i n the decision while Technical analysis i s given only 20%. When considering Technical analysis the only indicese used are: The Short Position index, not for the selection of common stocks but for use i n interpreting the market cycle. The Odd Lot index i s used for timing the market cycle. Charts are used by thi s investment manager for the timing of purchase and sales of i n d i v i d u a l common stocks. When considering Fundamental analysis: General economic conditions are used i n interpreting the market cycle and weighting the various industries i n which pension fund assets are invested. The analysis of f i n a n c i a l statements i s a l l important to the firm and i s given 90% importance. The significance of the P/ER i n fundamental analysis i s dependent on the company's growth rate i n the opinion of th i s investment manager. The higher the h i s t o r i c a l projected rates the higher the P/ER this firm w i l l accept. Management interviews are most important i n fundament-a l analysis - t h i s p a r t i c u l a r firm does the i r s by telephone. This manager rates the P/ER as important i n his i n -vestment decisions i n deciding whether a stock i s f u l l y priced or not. There i s much importance placed on the company i n questions projected growth rates. This manager seldom s e l l s - 98 -stocks which are i n r e l a t i v e up t r e n d s . A high P/ER i n the o p i n i o n o f t h i s investment manager only i n d i c a t e s what oth e r i n v e s t o r s t h i n k o f i t . T h e r e f o r e he does not t h i n k o f a hig h P/ER as an i n d i c a t i o n o f a growth stock or a d e s i r a b l e purchase. A hi g h P/ER stock he f e e l s i s not n e c e s s a r i l y an i n -d i c a t i o n of an o v e r p r i c e d stock nor does he t h i n k a low P/ER stock i s an i n d i c a t i o n of a growth stock or a d e s i r a b l e pur-chase . A h i g h P/Er stock he f e e l s i s not n e c e s s a r i l y an i n -d i c a t i o n of an o v e r p r i c e d stock nor does he t h i n k a low P/ER stock i s an i n d i c a t i o n o f u n d e r p r i c e d s t o c k s . Here again he f e e l s a low P/ER o n l y i n d i c a t e s what other people t h i n k o f i t . The P/ER i s not compared t o the P/ER of the popul a r i n d i c e s e . I t i s onl y c o n s i d e r e d i n r e l a t i o n t o the company's h i s t o r i c a l and p r o j e c t e d growth r a t e s . Such models as those o f Markowitz are not f o l l o w e d , nor does t h i s investment manager base h i s investment d e c i s i o n s on the R e l a t i v e Value Technique. The investment d e c i s i o n s are not based on the recom-mendations of investment brokers o r c o u n s e l l i n g f i r m s . How-ever, they do use the b a s i c r e s e a r c h o f investment brokers i n making t h e i r own d e c i s i o n s . THE INVESTMENT DECISION MAKING PROCESS I t i s very important t h a t we understand i n some d e t a i l the investment d e c i s i o n process and the d i s c i p l i n e s imposed on - 99 -investment managers with regard to equities for pension funds. Investment Research Generally most Trust companies have t h e i r own Research Departments, although one of the largest firms now favour sup-planting " i n house" research by outside work provided by broker-age houses and independent research firms. In any event, a l l Investment Research Departments make extensive use of the research f a c i l i t i e s of investment dealers and research firms i n Canada and the U.S. Hence the basis of a l l " i n house" research stems from recommendations made by the various brokerage houses. Based on the recommendations of the investment dealers, the investment managers proceed with an indepth study by one of the firms own analysts. Often t h i s involves interviews with senior management of the company under study. Interviews may be i n person or by telephone. Analysis The basis for indepth study by investment managers and analysts i s Fundamental Analysis, with fundamental factors accounting for at least 80% of the o v e r a l l investment de-cisions . Fundamental decisions normally proceed from general to the s p e c i f i c . An appraisal i s usually made of general world economic a c t i v i t y and the p o l i t i c a l s i t u a t i o n , followed by s p e c i f i c s of North America and Canada, with p a r t i c u l a r emphasis - 100 -on o v e r a l l corporate p r o f i t s . The next step may examine the role of the industry, world wide, e.g., o i l and energy resources, and relates i t within the Canadian and American economies and f i n a l l y the position of the company i s examined r e l a t i v e to i t s industry. This approach becomes d i f f i c u l t with the rapid growth of con-glomerates since i t i s necessary to try to determine the pro-portion of t o t a l sales and earnings accounted for by each of the industries i n which a company operates as well as the amounts derived from foreign sources. The next step could be a review of the management of the various companies within the industry under study. The analyst w i l l concern himself primarily with proven and a l e r t mangement which i s r e f l e c t e d i n Growth of Sales, Margin of P r o f i t and the Rate of Return on assets invested. The analysis of f i n a n c i a l statements i s a l l important in fundamental analysis and some investment managers place about 90% of t h e i r emphasis on f i n a n c i a l statements. However, the t r a i n i n g background of the analyst influences his decisions. If for instance, the analyst has a Commerce background he would place more emphasis on f i n a n c i a l statements than would an 2 analyst with an Economics or L i b e r a l Arts background. After a detailed interpretation of f i n a n c i a l state-ments , the analyst w i l l attempt to project future p r o f i t s and sales trends. The decision to s e l l often emanates from th i s study. After the analyst has decided whether the stock war-rants consideration to buy or s e l l , the analyst w i l l now - 101 -co n s i d e r the P r i c e t o Earnings R a t i o . The P r i c e to Earnings R a t i o A l l a n a l y s t s p l a c e a gre a t d e a l o f importance on the P/ER but are not g e n e r a l l y i n agreement on the i n t e r p r e t a t i o n o f the P/ER. Most a n a l y s t s do not c o n s i d e r a high P/ER to be de-s i r a b l e and o f t e n c o n s i d e r i t to be a s e l l s i g n a l p a r t i c u l a r l y i f i t i s i n range o f 30 or more. However, most of the a n a l y s t s are o f the o p i n i o n t h a t the P/ER does not n e c e s s a r i l y i n d i c a t e an under or o v e r p r i c e d stock but i t i s an i n d i c a t i o n of what other i n v e s t o r s t h i n k . G e n e r a l l y speaking the a n a l y s t w i l l p r e f e r a stock with a low P/ER, p o s s i b l y because o f the i m p l i e d low downside r i s k . When f u r t h e r c o n s i d e r i n g the P/ER the a n a l y s t w i l l study i t i n r e l a t i o n t o the popular i n d i c e s , t o other companies i n the i n d u s t r y and a l s o i n r e l a t i o n t o the company's p r o j e c t e d growth r a t e s . I t i s g e n e r a l l y c o n s i d e r e d t h a t the P/ER i s r e -l e v a n t t o determining r e t u r n p o t e n t i a l f o r a s p e c i f i c common stock. Since the s e l e c t i o n of stock i s based on f u t u r e r e t u r n and f u t u r e r i s k , the pr e s e n t P/ER (what you w i l l pay f o r an ex-pected stream of income) i s an important i n f l u e n c e i n the de-c i s i o n . The P/ER i s important i n d e c i d i n g whether a stock i s f u l l y p r i c e d or not. However, the good a n a l y s t w i l l t r y t o av o i d s e l l i n g stocks which are i n r e l a t i v e uptrends and most a n a l y s t s take the a t t i t u d e t h a t the hi g h e r the h i s t o r i c a l growth r a t e s , the h i g h e r the P/ER they w i l l accept. As one a n a l y s t has put i t "a high P/ER does not neces-- 102 -s a r i l y i n d i c a t e a good growth stock and t h a t p a s t growth w i l l continue or a c c e l e r a t e " . However, stocks w i t h good growth r a t e s and f u t u r e p r o s p e c t s may c a r r y a h i g h P/ER t h a t i s j u s -t i f i e d by q u a l i t y and marketing p o t e n t i a l and c o u l d t h e r e f o r e be purchased w i t h the prime o b j e c t i v e over the medium term being c a p i t a l g a i n . A low P/ER may i n d i c a t e to the a n a l y s t an undervalued s i t u a t i o n i n the p r e s e n t economic c l i m a t e and would i n v i t e f u r -t h e r i n v e s t i g a t i o n . The s i t u a t i o n may be any one o f a number of t h i n g s but a c y c l i c a l growth stock may have a low P/ER i n d i c -a t i n g a down t r e n d i n earnings and suggest a s e l l , whereas i f a low P/ER i s b e l i e v e d to be the r e s u l t of g e n e r a l economic c o n d i t i o n s , then the low P/ER may i n d i c a t e an u n d e r p r i c e d stock and a s i g n a l to buy f o r income and c a p i t a l g a i n . At t h i s p o i n t some a n a l y s t s use the R e l a t i v e Value Technique t o determine under and over valued stocks as compared to the popular stock i n d i c e s e . Here the P/ER o f a stock i s d i v i d e d by the P/ER of say the TSE I n d u s t r i a l index and p l o t t e d on semi l o g graph paper. A downward t r e n d i n d i c a t e s an under p r i c e d stock and an upward t r e n d i n d i c a t e s an o v e r p r i c e d s t o c k . At t h i s p o i n t fundamental a n a l y s i s i s g e n e r a l l y com-p l e t e d and the a n a l y s t w i l l now look f o r f u r t h e r j u s t i f i c a t i o n o f h i s d e c i s i o n . T h i s i s u a u a l l y attempted by T e c h n i c a l A n a l y s i s which o f t e n p l a c e s up to 20% weight on the a n a l y s t s d e c i s i o n . T e c h n i c a l A n a l y s i s G e n e r a l l y the a n a l y s t uses Fundamental A n a l y s i s t o - 103 -select common stocks while Technical Analysis i s used i n the timing of purchases and sales. This study revealed that technical analysis was limi t e d to: The Short Position Index - The Odd Lot Index Charting. The Short Position Index was not used i n the sel e c t i o n of common stocks, but the t o t a l short position was used i n i n -terpreting the market cycle. The Odd Lot Index as with the Short Position Index was not used i n the selection of stocks but only for timing the market cycle. Charting Charts seem to be the most popular of the technical analysis methods. This i s primarily because they can be employed for long term investment planning, based on fundamentals, or for short term technical analysis of the market. The analyst w i l l rarely construct his own chart since there are many excellent chart services available. Charting, as far as the analyst i s concerned, i s lim i t e d to simply de-termining trend l i n e s and resistance l e v e l s . He i s not nor-mally interested i n formations, reversal patterns, channels, gaps, etc. Their theory i s that the charts w i l l give some i n -dication of timing, by history repeating i t s e l f or determining investor buying habits. The analyst feels that i f the stock i s weak the chart w i l l show i t - i f i t i s strong t h i s also - 104 -w i l l be indicated. In essence aft e r the analyst has completed a thorough fundamental analysis, he w i l l attempt to confirm his opinions and discover timing of market swings through charting. Investment Committees Usually when the research analysts have completed t h e i r analysis of a company and have prepared i t s study and re-commendations i t i s presented to members of some form of a Management Investment Committee. If the study concerns a com-pany already approved by a senior or Executive Investment Com-mittee, the Management Investment Committee w i l l discuss the company and i f i t i s given f i n a l approval, the various branches investment o f f i c e r s w i l l be given approval to buy or s e l l . If the study covers a company not already approved by the Executive Investment Committee, i t w i l l be submitted to them for consideration at t h e i r next meeting and i f approved, included i n the approved l i s t . The Executive Investment Committee This type of committee usually consists of the Trust Company's directors and may meet on a monthly basis. The ap-proved l i s t provides a guide to the investment p o l i c y f o r management throughout the firm. The Approved L i s t This i s not merely a guide but a highly s o p h i s t i c -ated a n a l y t i c a l guide and probably rates each stock i n terms of - 105 -estimated growth pro jec t ions , the company's pro ject ions and the company's expectations over the next two or three years . Here then i s the usual procedure i n making inves t -ment decis ions i n trusteed pension funds. - 106 -CHAPTER IX SUMMARY We now see that pensions i n Canada f a l l into two broad categories, determined by the funding methods. The In-sured Plan i s a contract entered into with an insurance com-pany. I t i s an i n f l e x i b l e plan that guarantees an annuity re-gardless of earnings and the assets become the property of the insurance company. Then there i s the Trusteed Method usually entered into with a t r u s t company under the guidance of an actuary. Under this method there i s no guarantee as to benefits but the assets are the property of the fund and the income from the assets can increase the benefits or reduce the costs. The trusteed plans i n turn f a l l into two categories -where the cost i s known but the benefit i s not, and where the benefit i s known but the cost i s not. What then constitutes the cost? It i s -the t o t a l of the benefits paid out plus the administrative expenses minus the amount of the employees' contributions minus the earnings of the fund. The only two variables are the administrative CHAPTER VIII INDEX TO FOOTNOTES Page 90 G.I.CO., "Garbage In Garbage Out", when Referring to EDP or Computers. 100 Information Regarding the Educational Background of the Investment Managers was the Result of Actual Questions Put to the Persons Being Interviewed and from Personal Experience whilst Em-ployed i n Various F i n a n c i a l Inter-mediaries . - 107 -expenses and the earnings and since the administrative expenses are to a l l intents and purposes fixed costs, the earnings on investment y i e l d has the greatest e f f e c t of reducing the cost. We have seen that an increase i n return of 1/2 of 1% per annum may r e s u l t i n a cash saving of 10 to 15% or an increase i n bene-f i t s of 8 to 12%. Therefore, the y i e l d of the fund becomes most important since i t can be posit i v e or negative. Now the i n -vestment manager must decide whether a high dividend payout or stock appreciation w i l l contribute most to the y i e l d of the assets. As we know the y i e l d on any security depends on the earnings per share or E.P.S., since the earnings or expected earnings, determine the dividend payout and the appreciation i n price . There i s also another consideration, often overlooked by investment analysts, that i s what constitutes earnings per share. Earnings were derived by using two methods of account-ing; the current operating concept or the a l l i n c l u s i v e con-cept, while per share data was stated by common stock or re-sidual s e c u r i t i e s outstanding, or by the average common stock r e f l e c t i n g p o t e n t i a l d i l u t i o n . In order to compare E.P.S., the analyst must reduce earnings and per share data to a common base. However, when considering firms with complex c a p i t a l structures he must also consider not only common stock equiv-alents, but also primary earnings per share as well as f u l l y d i l u t e d E.P.S. It now becomes obvious that i n order to make meaningful comparisons, the analyst may have to develop a schedule of E.P.S. amounts where each amount i s associated with a given p o t e n t i a l future market price for common stock , - 108 -by employing t h i s r elationship between the commons market price and the l i k e l i h o o d of actual conversion or exercise, the analyst may determine the portion of the firms current income l i k e l y to be attributed to a single share i n the event of each of several d i f f e r e n t future occurrences. Now that we can more accurately understand and com-pare earnings per share we can determine the relationship be-tween p r i c e , earnings per share and corporate growth. The p r i c e that w i l l be paid for a security has a d e f i n i t e r e l t i o n s h i p to the Present Value formulae which i s assumed to be based on future growth. The P.V. formulae can be convertedi.into a c a p i t a l i z a t i o n model where the current p r i c e (P),is equal to the summation of a l l future earnings per share (E) ydiscounted at the investor's discount rate or op-portunity cost (K). This model i s based on three assumptions -a constant growth rate, an i n f i n i t e time horizon and contin-uous compounding. The current stock price 'P' i s then equal to current earnings growing at rage 'G' discounted at a rate 'k' over i n f i n i t e l y small time periods. If earnings are re-tained and not available to the stockholder they should not be c a p i t a l i z e d . I f the firm can reinvest at a greater return than the stockholder, the investor w i l l be w i l l i n g to pay a premium to have the firm invest on his behalf. The price earnings r a t i o i s a concept based on the Present Value formula assuming s p e c i f i c values for earnings growth, duration, discount rates and dividend payout. There-fore, analysts should focus on the assumptions behind the - 109 -value of each price earnings r a t i o in order to make more ap-propriate investment decisions. A l o g i c a l question now would be how i s corporate growth sustained over the time horizon? In theory stock prices are a function o f the P/ER and expected earnings per share which are a major determinant of corporate growth. Earnings per share i n turn depend on f i v e variables: Margin of p r o f i t from sales. Turnover r a t i o of sales to t o t a l c a p i t a l . The leverage e f f e c t employed. - The after tax rate. The Bank value of the common share. Any change i n earnings can be expressed as changes i n these f i v e variables. However changes i n margin, turnover, leverage and rate of earnings a f t e r tax, cannot be r e l i e d upon to sustain growth over a protracted period. Changes i n book value or retained earnings are the only sustainable source of growth available to a company. Hence the return on t o t a l i n -vestment has a di r e c t bearing on the growth of earnings which underly the stock market investment. The analyst must now separate the elements contributing to sustained growth which are - the return on t o t a l investment and the retention rate. Once the analyst has a comprehensive knowledge of the derivation of the Price Earnings r a t i o s i t i s esse n t i a l that he can u t i l i z e t h i s fundamental concept to value common stocks. In order to do so he should study the emperical evidence available to judge the v a l i d i t y of the P/ER as a - 110 -v a l u a t i o n t o o l . He must d e c i d e whether t o make a market o r i n -d u s t r y comparison o f P/ER. These e m p e r i c a l s t u d i e s show t h a t -The market v a l u e s t h e e a r n i n g s o f some i n d u s t r i e s h i g h e r t h a n o t h e r s . The market v a l u e s t h e e a r n i n g s o f companies i n t h e same i n d u s t r y d i f f e r e n t l y . P/E R a t i o s v e r y s i g n i f i c a n t l y o v e r p r o t r a c t e d p e r i o d s . Here we f i n d t h a t t h e most i m p o r t a n t c h a r a c t e r i s t i c c o n t r i b -u t i n g t o P/ER d i f f e r e n c e s i s t h e e x p e c t e d growth i n e a r n i n g s ; however, d i v i d e n d e x p e c t a t i o n , v o l a t i l i t y o f s a l e s and e a r n -i n g s , c a p i t a l s t r u c t u r e and o t h e r f a c t o r s mentioned i n our s u s t a i n e d growth d i s c u s s i o n s a l s o c o n t r i b u t e t o t h i s v a r i a n c e . As we c o n s i d e r t h e e m p e r i c a l s t u d i e s o f t h e v a r i o u s w r i t e r s t h e r e i s a s t r o n g s u g g e s t i o n t h a t t h e low P/ER s t o c k s o f t h e p o p u l a r i n d i c e s e have o u t p e r f o r m e d the h i g h m u l t i p l e s t o c k s and t h a t i f a h i g h m u l t i p l e was an i n d i c a t i o n o f a h i g h growth r a t e , i t was a poor judge o f growth. I t has a l s o been o b s e r v e d t h a t by m u l t i p l e r e g r e s s i o n a n a l y s i s i t i s p o s s i b l e , under c e r t a i n assumptions and con-d i t i o n s , t o p l a c e a v a l u e on common s t o c k s i n terms o f m u l t i p l e s o r t h e P/ER. G e n e r a l l y we have found t h a t low P/ER s e c u r i t i e s have o u t p e r f o r m e d t h e h i g h P/ER s t o c k s , a l s o t h a t t h e s e a re u n d e r p r i c e d s t o c k s h a v i n g low m u l t i p l e s t h a t have been o v e r -l o o k e d i n the market. T h i s l e a d s us t o p l a c e some degree o f c o n f i d e n c e i n t h e R e l a t i v e V a l u e Technique from w h i c h we s h o u l d - I l l -determine whether there i s j u s t i f i c a t i o n for the undervaluing of certain stocks. We are also led to believe that high P/E r a t i o stocks often represent prices which investors bid too sharply i n r e l a t i o n to actual growth and the i n f l a t e d portion o the price does not j u s t i f y the purchase of high P/E r a t i o stock In order to determine the e f f e c t of the P/ER on i n -vestment decisions i n Trusteed Pension Funds i n Canada/personal c a l l s were made on investment managers i n the Vancouver area and questionnaires were sent to Head Offices of fi v e n a t i o n a l l y based t r u s t companies and two Vancouver based firms dealing i n pension funds. The questionnaire was designed to glean as much information as possible regarding the investment managers i n -vestment procedures. The investment manager was asked to com-ment on his attitudes toward: Technical and Fundamental Analysis High and Low Multiple Stocks P o r t f o l i o Models Pr o b a b i l i t y Theory The Relative Value technique Outside Counselling Services. Generally the response was very good. The findings, based on the questionnaire, offered considerable insight into the decision making process. The Findings Most t r u s t companies have t h e i r own Research Depart-ments although some favour outside work carr i e d on by brokerage - 112 -houses and independent research firms. In a l l cases Investment Research departments make extensive use of research f a c i l i t i e s of investment dealers and research firms i n Canada and the U.S. The investment managers use the recommendations of investment dealers as a basis for t h e i r analysis and carry out detailed indepth studies of the stocks so recommended. Analysis The basis of indepth study i s fundamental analysis accounting for about 80% of o v e r a l l investment decisions. Fun-damental analysis normally proceeds from the general to the s p e c i f i c or from general world economic and p o l i t i c a l a c t i v i t y , through the industry, down to the i n d i v i d u a l firm. The analysis of the firms f i n a n c i a l statements i s a l l important and some i n -vestment managers place about 90% of t h e i r emphasis on f i n a n c i a l statements. Technical analysis i s used but seldom accounts for more than 20% of the o v e r a l l investment decision. Primarily i t i s used only to indicate the best timing for buy/sell de-cisions and also to " j u s t i f y " fundamental decisions. Of a l l the technical analysis methods charting i s the one most used although the Short Position Index and the Odd Lot Index are used to lesser degrees. The Price Earnings Ratio A l l analysts place a great deal of emphasis on the P/ER but are not i n general agreement on i t s interpretation. Some consider that the P/ER i s important i n deciding whether a stock i s f u l l y p r i c e d or not, w h i l e others are o f the o p i n i o n t h a t the P/ER does not i n d i c a t e an under or o v e r p r i c e d s t o c k , but merely what other i n v e s t o r s may t h i n k . These views are not n e c e s s a r i l y i n c o n f l i c t . G e n e r a l l y speaking the a n a l y s t w i l l p r e f e r a low P/ER stock p o s s i b l y because o f the i m p l i e d low downside r i s k . However a good a n a l y s t w i l l t r y to a v o i d s e l -l i n g s t o c k s which are i n r e l a t i v e uptrends and most a n a l y s t s take the a t t i t u d e t h a t the h i g h e r the h i s t o r i c a l growth r a t e s the h i g h e r the P/ER they w i l l accept. A l l u s u a l l y agree t h a t a P/ER of 30 or more i n d i c a t e s a s e l l s i g n a l . G e n e r a l l y the P/ER of a stock i s compared to o t h e r stocks i n the i n d u s t r y and t o the popular i n d i c e s e . However, few a n a l y s t s use the R e l a t i v e Value Technique per se. Although a n a l y s t s use a type or m o d i f i e d R e l a t i v e Value Technique, none based t h e i r a n a l y s i s or d e c i s i o n s on P r o b a b i l i t y Theory or In-vestment Models of the i l k o f H. Markowitz and o t h e r s . The main reason was t h a t few a n a l y s t s understood such models and those who d i d f e l t they c o u l d o n l y work i n a p e r f e c t market. F u r t h e r , i f the model was u s e f u l there would be a g r e a t t e n -dency f o r a l l pension funds to buy the same p o r t f o l i o s and by so doing i n f l a t e the p r i c e s of the s t o c k s . The D e c i s i o n Making Process A n a l y s t s agreed t h a t Mutual Funds and Pension Funds have to some extent the same problem. Because of t h e i r s i z e they are mutually unable to be t o t a l l y l i q u i d at any one time. The sheer magnitude o f a program to s e l l e q u i t i e s i n a f a l l i n g - 114 -market would c e r t a i n l y help to push that market down faster and further. Pension Funds are a l i t t l e more fortunate than mutual funds i n that they have a po s i t i v e cash flow. Usually when the analyst has completed his study and recommendations i t must be presented to a Management Committee. If the company i s on the approved l i s t i t w i l l be discussed and i f approved for further purchase or sale, various branch investment o f f i c e r s w i l l be so advised. If the study i s of a company not already approved by the Committee, i t w i l l be sub-mitted for further consideration at t h e i r next meeting and i f approved w i l l be placed on the approved l i s t for next month which could a f f e c t the timing considerably. In my opinion a good general rule to follow would be: "When a l l other things are equal, buy the stock with the lowest Price to Earnings Ratio". - 115 -BIBLIOGRAPHY A Study of Canadian Pension Plans, 1969, Published by The National Trust Company. Canadian Handbook of Pension and Welfare Plans, by William M. Mercer Limited, C.C.H. Canada Ltd., 1967. Canada Trust Pooled Pension Funds, Annual Reports, 1969, 1970, 1971. Canada Permanent Trust Company, Fina n c i a l Statements, Pooled Investment Funds for Employee Benefits, 1969, 1970, 1971. Montreal Trust Company, Multiple Fund Annual Reports, 1969, 1970, 1971. National Trust Company, Pooled Investment Funds, Auditors Report, 1969, 1970, 1971. Royal Trust Company, C l a s s i f i e d Investment Funds for Pension Trusts, 13th, 14th, 15th Annual Reports. Fi n a n c i a l Post -Pension Funds i n Canada, Published by The Royal Trust Company. The Trust B u l l e t i n , October, 1966. The Commercial & Fi n a n c i a l Chronicle, 1965. Bank Administrative I n s t i t u t e , 1968. Proceedings from the F i r s t Annual Convention. Canadian Pension Conference, 1967. F i n a n c i a l A n a l y s t s J o u r n a l , January - February, 1970, May - June, 1970, J u l y - August, 1970. American I n s t i t u t e o f C e r t i f i e d P u b l i c Accountants, May, 1969. A Theory of F i n a n c i a l A n a l y s i s , Edgar Lerner and W i l l i a m C a r l e t o n (New York: Harcourt Brace & Weild Inc.) 1966. Common Stocks as Long Term Investments, Edgar Lawrence Smith (MacMillan, 1923). - 116 -Investment Analysis & P o r t f o l i o Management, Cohen & Zinburg (Richard D. Irwin, Inc.) 1967, Homewood, I l l i n o i s . Security Analysis, P r i n c i p l e s & Techniques, Graham Dodd & Cottl e , McGraw-Hill Book Co. Inc., 1962, New York. Readings i n Fi n a n c i a l Analysis and Investment Management, by Edgar Lerner, Richard D. Irwin Inc., 1968, Homewood, I l l i n o i s . A Tool i n Investment Decision-Making, Whitbeck & Kisor i n Frontiers of Investment Analysis, E.B. Frederickson, International Textbook Co., 1966, Scranton, Pennsylvania. Pooled Pension Fund Survey, Towers Perrin Foster & Crosby, 1970. - 117 -ANNEX 8 A TRUSTEED PENSION FUND INVESTMENT QUESTIONNAIRE General This Questionnaire attempts to determine to what extent the Price to Earnings Ratio of equities influences investment decisions i n Trusteed Pension Funds. In most cases the questions may be answered by either a q u a l i f i e d or unqualified NEVER, OC-CASIONALLY, or ALWAYS. In other cases a percentage may be used, while i n some cases a short explanation may best answer the question. 1. To what extent are your investment decisions for common stock i n pension funds based on: a) Technical analysis? b) Fundamental analysis? 2. To what extent are your Technical analysis decisions based on: The Dow Theory The Volume Index The Breadth Index The High-Low Index The Short Position Index The Odd Lot Index The Confidence Index Charting Other - (Please describe)? 3. To what extent are your Fundamental analysis decisions based on: General Economic Conditions - 118 -A n a l y s i s of F i n a n c i a l Statements The P r i c e Earnings R a t i o Other - (Please d e s c r i b e ) ? 4. To what extent does the P/ER o f a common stock i n f l u e n c e your investment d e c i s i o n s f o r pension t r u s t s ? 5. Do you c o n s i d e r a h i g h P/ER as d e s i r a b l e and an i n d i c a t i o n of a growth stock t o the purchased p r i m a r i l y f o r c a p i t a l gain? 6. Do you c o n s i d e r a h i g h P/ER stock as an i n d i c a t i o n o f an o v e r p r i c e d s t o c k , to be avoided or sold? 7. Do you c o n s i d e r a low P/ER stock to be u n d e r p r i c e d , t o be purchased p r i m a r i l y f o r : a) Income b) C a p i t a l Gain? 8. Do you c o n s i d e r a low P/ER stock to be u n d e s i r a b l e ? i . e . , I n d i c a t i v e o f a poor or stagnant s i t u a t i o n ? 9. Do you c o n s i d e r the P/ER o f a stock i n r e l a t i o n t o the P/ER of the popular i n d i c e s e i n d e c i d i n g whether the P/ER of the p a r t i c u l a r stock i s h i g h or low? 10. To what extent do you: a) F o l l o w Markowitz's model of p o r t f o l i o s e l e c t i o n ? That i s : Consider the pension i n v e s t o r s regard a h i g h expected r e t u r n as d e s i r a b l e and u n c e r t a i n t y of r e t u r n as un-d e s i r a b l e . F u r t h e r , t h a t they are faced w i t h a l i s t o f n s e c u r i t i e s and regard R i , the r e t u r n on s e c u r i t y i , as as a random v a r i a b l e , w i t h a mean U i and a v a r i a n c e o f O i i Moreover O i j , the c o v a r i a n c e between the r e t u r n on any two s e c u r i t i e s i s d e r i v e d and known. Then: a) Der i v e a s e t of e f f i c i e n t p o r t f o l i o s . - 119 b) Select from the e f f i c i e n t set the one p o r t f o l i o that provides the pension investor with a most suitable combination of r i s k and return based on his u t i l i t y function, i . e . , his attitude toward r i s k . (b) Do you consider the return as a p r o b a b i l i t y function at a l l ? (c) Do you use the Relative Value Technique? 11. To what extent do you base your investment decisions on the recommendations of various counselling firms and in-vestment brokers? 12. Please describe any other methods you use to make invest-ment decisions i n your pooled pension funds. - 120 -INVESTMENT PORTFOLIO OF COMPANY A - 1969-1970 ANNEX 8 B 1 1969 1970 STOCK VALUE SHARES P/ER VALUE SHARES P/ER Bank of Commerce $ 1072' 55000 14.9 $ 1600 80000 14. 4 Royal Bank 1148 55000 18.9 1700 80000 15.9 Toronto Dominion 1086 55000 18.5 1202 65000 16.1 Seagrams 1537 30000 15.5 1860 40000 14.6 Hiram Walker 1421 35000 14.6 2223 53900 15. John Labatt 1306 50000 22. 1112 50000 15. 8 Molsons Ltd. 770 35000 17.8 374 28000 14. 8 Dupont 224 7000 15.1 . 119 7000 29. 8 Union Carbide 273 15000 15.2 ~1<74 15000 15.4 Canada Packers 1137 70000 14. 1620 80000 12. McMillan Bloedel 615 20000 15.9 756 31500 42. Alcan 597 20000 11.7 565 25000 9.4 Algoma Steel 425 25000 22.6 315 25000 16.5 Dominion Foundries 543 25000 10. 487 25000 8.5 Steel Co. of Canada 559 25000 9.8 546 25000 17.5 Dominion Stores 213 15000 12.4 195 15000 10. 3 Hudsons Bay Co. 615 30000 21. 7 140 11500 23.3 Met. Stores 515 13550 23.0 165 9475 19.7 Simpsons Ltd. 1132 60000 27.6 960 60000 25.5 Woodwards Stores 460 25000 15.4 520 35000 15.9 Cassiar Asbestos 258 15000 15.4 585 30000 16.0 Hollinger Mines 427 13000 15.0 545 20000 12.4 International Nickel 1173 30000 25.3 1487 35000 16. 8 Kerr Addison Mines 365 25000 11.9 275 25000 15. West Coast Transmission 725 25000 25. 3 403 25000 46. 8 Moore Corp. 1295 40000 24.7 1317 44300 25.9 Southam Press 1440 24000 23.5 942 20000 20.6 B e l l Telephone 935 20000 14. 3 1065 25000 12.8 B.C. Telephone 690 10000 13. 885 15000 12.' Calgary Power 260 10000 14. 3 660 30000 11.6 Consumers Gas 345 20000 17.7 391 27000 14.4 Int. U t i l i t i e s 586 15000 12.7 120 5300 13.7 Union Gas Co. 725 50000 15. 3 650 50000 19.5 C P . Railway 891 11000 15. 3 "641 11500 11.5 Oshawa Wholesale 36.7 481 000 35000 30.2 A b i t i b i Paper 17.1 393 50000 41. A l l values i n thousands, Continued Page 2.. Page 2 -STOCK Falconbridge Nickel Noranda Mines Gulf O i l Imperial O i l Texaco O i l Shell O i l Canada Thompson News Ltd. Toronto Star Abel Black Corp. 1969 VALUE SHARES $ 1207 60000 1230 60000 768 39150 25000 ESTIMATED AVERAGE P/ER 1969 ANNEX 8 B cont 1970 P/ER VALUE SHARES P/ER 17. $ 560 4000 14. 5 16.1 414 15000 12.9 20.7 1230 80000 16. 28..-V 1340 80000 26. 12.2 562 25000 9.6 19.6 284 11250 17. 8 26.7 437 25000 27.7 130 10000 10. 7 16.7 42 33666 15000 13.5 12.93 ESTIMATED AVERAGE P/ER 1970 = 14. 85 - 122 - ANNEX 8 INVESTMENT PORTFOLIO OF COMPANY B - 1969-1970 1969 1970 STOCK VALUE SHARES P/ER VALUE SHARES P/ER Bank of Montreal $ 114 9000 14.9 $ 344 25000 14.4 Bank of Nova Scotia 130 9000 20.2 508 30000 16. 3 Bank of Commerce 135 10000 19.4 334 21500 16. Royal Bank of Canada 148 9625 18.9 443 25000 15.9 Toronto Dominion 131 10000 18.5 209 15500 16.1 Canadian Breweries 55 7000 18.3 12.9 John Labatt Ld. 95 6000 21.9 194 10000 15. 8 Seagrams Ltd. 86 3200 15.5 213 7000 14.6 Molsons Ltd. 133 7400 17.8 287 21700 14. 8 Hiram Walker 140 5000 14.6 338 12300 15. C I L 63 2900 11.1 12.8 Chemceil Ltd. 82 6000 16.7 11. 3 Dupont of Canada 55 1200 15.1 29.8 Union Carbide 59 2300 15.2 15.4 I.A.C. 46 2000 12. 13. 3 Hudsons Bay Co. 16 1000 21. 7 23.3 Oshawa Wholesale 209 7500 36.7 430 15000 30.27 Rothmans 117 4000 5.1 315 14600 10.7 Simpsons-Sears 25 2000 32.2 115 4500 29. Simpsons Ltd. 85 3000 27.6 104 7000 25.5 Ze l l e r s 197 12000 26.1 197 12000 25.2 Woodwards Stores 25 2000 15.4 260 15000 15.9 A b i t i b i Paper 35 3200 17.1 41. Great Lakes Paper 65 2500 17. 3 65 2500 13.6 McMillan Bloedel 59 2500 15.9 184 6800 42. Cominco Ltd. 72 * 2500 15. 72 2500 18.6 Falconbridge Nickel 154 1800 17. 154 1800 14.5 Hudsons Bay Mining 98 1300 8. 160 2000 12.3 International Nickel 330 9000 25. 3 742 20200 16. Noranda Mines 183 8000 16.1 343 16000 12.9 Massey Ferguson 89 3800 12.4 7.9 B r i t i s h American O i l 133 4000 20.7 282 16300 16. Texaco O i l 94 3000 12.2 250 10000 9.6 Imperial O i l 102 2050 28. 306 24200 26. Alberta Gas Line 78 2200 16.6 373 10000 17.1 Inter P r o v i n c i a l 114 7000 21. 473 13000 24.6 Trans Canada Pipe 67 2000 33.5 24. 3 Algoma Steel 84 3000 22.6 6.5 Alcan Ltd. 190 6000 11.7 9.4 Continued Page 2 Page 2 -STOCK Dominion Foundries Stelco B. C. Telephone B e l l Telephone Calgary Power Consumers Gas International U t i l i t i e s Northern & Central Gas NS Light & Power FPE Pioneer E l e c t r i c Union Gas Co. Can. Tire Corp. R.L. Cain C. P.R. Greyhound Lines Standard Broadcasting Moore Corporation Crush International C & D Sugar Consumers Distrb. Co. Cunningham Drugs Reitman's Ltd. Scott Lasalle Ltd. Silverwood Dairies Price Co. Ltd. Home O i l 'A' Husky O i l Shell O i l Canada Ltd. Algoma Central Railway Whitepass Yukon Corp. Canadian U t i l i t i e s Ltd. Acres Ltd. Block Bros. Ltd. Famous Players Thompson News Ltd. 1969 VALUE SHARES 220 11000 193 9000 81 1200 160 3500 58 2500 197 13000 225 5500 231 18000 32 3000 95 3000 92 10000 85 1500 190 12000 203 3500 163 12000 1 100 183 10000 6535 ESTIMATED AVERAGE P/ER 1969 = 123 - ANNEX 8 B 2 P/ER VALUE SHARES P/ER 10. $ 277 14800 8.5 9.8 308 14240 17.5 13. 81 1200 12. 14.3 209 4500 12. 8 14.3 58 2500 11.6 17.7 343 22500 14.4 12.7 512 15000 13.7 22.4 446 30000 14.2 12.8 10.1 13.7 8.5 15. 3 200 21800 19.5 27. 178 3000 21. 23. 190 12000 29. 3 15.3 360 5575 11.5 20.6 200 15000 16.2 31.5 22.6 24.7 404 18500 26. 22.3 117 29500 20. 12.2 96 2425 10.3 84 6000 28.1 34 2000 10. 76 4000 9.2 65 2150 14.5 317 14000 11. 95 6675 29. 67 3000 19.2 125 5600 23.6 85 3000 17. 8 87 10000 9.3 70 3000 23. 267 7000 8.6 100 5000 43.5 203 27000 16.7 101 6500 13. 4 56 3000 27. 7 13635 15. 32 ESTIMATED AVERAGE P/ER 1970 = 17.5 x " ANNEX 8 B.3 INVESTMENT PORTFOLIO OF COMPANY C - 1969-1970 1969 1970 STOCK VALUE SHARES P/ER VALUE SHARES P/ER Acklands Ltd. $ 348 20000 13.3 ? 313 29900 7.1 Bank of Montreal 2 29 191000 14.9 3300 200000 14.4 Bank of Commerce 2227 172400 19.4 3825 180000 16. Royal Bank of Canada 2598 172400 18.9 4251 190000 15.9 Seagrams Ltd. 4203 115100 15.5 5425 100000 14.6 John Labatt Ltd. 865 85600 21.9 2439 85600 15.8 Hiram Walker 2308 75200 14.6 4110 85200 15. Dominion Stores 1955 109300 12.4 1552 115000 10. 3 Simpsons Ltd. 2582 85550 27.6 3420 180000 25.5 Simpsons-Sears Ltd. 460 14825 32.2 29. Steinbergs Ltd. 'A' 2185 120000 14.8 1650 120000 10. 3 Neonex International 329 20000 18.4 250 50000 6.2 Moore Corp. Ltd. 932 65475 24.7 2447 65475 25.9 Falconbridge Nickel 3916 40000 17. 5287 30000 14.5 International Nickel 4222 114800 25.3 4950 100000 16.8 Noranda Mines Ltd. 3241 139000 16.1 4380 120000 12.9 Labrador Mining 861 24150 13.7 1039 33000 14.5 Pine Point Mines 468 10000 8.0 850 25000 7.2 Placer Development 1746 60700 22.7 3220 70000 22. 8 MEPC Cdn. Properties 294 90000 26.2 420 100000 15.1 Southam Press 1316 36745 23.5 2447 36970 20. 6 Pembina Pip l i n e 338 15300 14.7 571 22400 14.9 ATCO Industries 842 55000 30. 975 65000 22.2 McMillan Bloedel Ltd. 902 42800 15.9 1755 52800 42. Weldwood of Canada 1646 67600 11.2 1550 79500 -Gulf O i l Canada 3193 87055 20.7 3123 170000 16. Shell O i l Canada Ltd. 1624 64325 19.6 1205 41400 17.8 Cdn. Industrial Gas 1443 60000 27.1 1980 180000 21.6 Husky O i l Canada 2116 100000 24. 1670 135000 23.6 Union O i l Canada 1278 29300 24.1 1267 30000 18.4 Consumers Gas 2314 150000 17.7 1484 93500 14.4 International U t i l i t i e s 4753 139700 12.7 4125 150000 13.7 Northern & Central Gas 2448 176025 22.4 2295 180000 14.2 Canron Ltd. 730 42900 16.6 . 670 42900 14.5 Dominion Foundries 4274 200000 10. 4350 200000 8.5 Massey Ferguson Ltd. 1113 50000 12.4 1487 100000 7.9 Steel Co. of Canada 4624 200000 9.8 4475 200000 17.5 Argus Corp. Ltd. 1355 86600 22. 1173 113100 24. 6 Canadian P a c i f i c Railway 1505 25000 15. 3 1621 25000 11. 5 Page 2 -1969 STOCK VALUE SHARES Auto E l e c t r i c Service $ 315 18000 Bethlehem Copper 297 15000 Bombardier 107 6500 C A E Industries 338 30000 Central Dynamics 57 7000 C h u r c h i l l Copper 196 30000 Consol Computer 196 11530 Courvette Provost 204 35000 D'Allairds Mfg. 201 26000 Douglas Leasehold 81 13500 Great Lakes Nickel '322 50000 Great West Saddlery 118 10000 Industrial Wire 124 27900 Inspiration Ltd. 172 100000 International Systcoms 560 20000 Kelly Douglas Co. 'A' 217 30000 Lornex Mining Corp. 322 30000 Magnum Consol Mining 302 60000 0 S F Industries Ltd. 158 9750 Reitman's Canada Ltd. 184 15000 Reitman's Canada Ltd. 'A1 59 5450 Standard Paving 108 10000 Universal Sections 6 400 V e r s a t i l e Mfg. Ltd. 'A1 114 10000 V e r s a t i l e Mfg. Ltd. 125 80847 10000 Famous Players Acklands Ltd. Cdn. 'A' Banque Canadienne Nationale P r o v i n c i a l Bank of Canada Genstar Ltd. Chemcell Ltd. A b i t i b i Paper Co. B.C. Forest Products Consolidated Bathurst Asbestos Corp. Ltd. Cominco Ltd. Rio Algom Mines Kerr Addison Mines Mattagami Lake Mines 125 - ANNEX 8 B 3 cont 1d 1970 P/ER VALUE SHARES P/ER 95. % 110 18000 18. 11.2 300 15000 10. 28. 14. 3 19. 8 147 30000 10.2 60. -13.4 173 33000 10. - 900 92240 -14.7 232 35000 6.1 - 201 26000 -41.8 13. 3 66.3 287 50000 11. 8 70. 11.8 - 150. — 13 15000 — 16.5 12. 20. 277 30000 10. - 132 60000 2.1 66.6 20.8 10.31 344 15750 9.17 - 101 5722 -81.2 73 10000 8.6 - 2.2 - 64 20000 -60. 35 10000 -20. 744 62000 13.4 13.3 221 260000 7.1 12.7 460 40000 11. 13. 630 60000 14.1 12. 823 68600 15.4 16.7 580 80000 11. 3 17.1 568 50000 41. 15. 1320 40000 138. 56. 1481 68500 -11. 530 20400 15. 15. 575 20000 18.6 17.4 573 30000 20.2 11.9 506 36200 15. 15.5 446 15000 17. Continued Page 3... Page 3 -1969 STOCK VALUE SHARES Imperial O i l Canadian G r i d o i l Ltd. Dome Petroleum Ltd. Jefferson Lake Ltd. Triad O i l Co. Ltd. MEPC Cdn. Properties 'A' B e l l Canada Bankend Mines Ltd. Edson Holdings Ltd. Con. PFD Edson Holdings Ltd. Identicard Ltd. Identicard Conv 'A' J.D. Car r i e r Shoe Co. Leon's Furniture Ltd. Microsystems International Ltd. Montreal City Savings Bank Shepard Casters Canada Supertest Petroleum Ltd. ESTIMATED AVERAGE P/ER - 1969 = 126 - ANNEX 8 B 3 P/ER VALUE SHARES P/ER 28. $ 2200 100000 26. 48. 176 20000 -38. 1610 20000 20.8 20.1 195 15000 71. - 173 45000 20.9 26.2 785 1000000 15.1 14. 3 2100 50000 12. 8 - 156 30000 -- 100 10000 -- 1 10000 -- 33 5600 -- 70 70000 -20. 174 15000 40.7 11. 275 55000 7. - 390 40000 -10. 262 25000 8.8 - 121 25000 30. 158. 255 113088 6900 200. 17.83 ESTIMATED AVERAGE P/ER - 1970 = 17. 81 - 127 - ANNEX 8 B 4 INVESTMENT PORTFOLIO OF COMPANY D - 1969-1970 1969 1970 STOCK VALUE SHARES P/ER VALUE SHARES P/ER C D R H Ltd. 3 70 5000 10.9 $ 17.8 Canada Packers 310 17500 14. 401 22000 12. Canadian Hydrocarbons 261 10000 16.4 261 20000 10.5 Bank of Commerce 200 15000 19.4 4000 24000 16. Cdn. Tire Corp. 'A' 190 5000 29.2 -Cdn. T i r e Corp. 101 8000 27. 249 10000 21. Cara Ops Ltd. 117 6000 37. 14. Charter Industries Ltd. 120 11000 - 260 22000 -Cominco Ltd. 168 5000 15. 18.6 Computel Systems 91 2000 - -Consumers Gas 238 11000 17.7 342 17000 14.4 Crush International 275 15000 22.3 20. Seagrams 201 5000 15.5 506 11000 14.6 Dominion Foundries 332 15900 10. 431 20000 8.5 Dustbane Ltd. 214 10000 24.4 214 20000 18.2 Pioneer E l e c t r i c 112 5010 13.7 112 5010 8.5 Falconbridge Nickel 600 6000 17. 685 6500 14.5 Famous Players 449 10000 20. 318 28400 13.4 Ford of Canada 251 1000 7.5 251 5000 6.8 French Petroleum 76 10000 34. 31.6 Harveys Foods 315 30000 24.8 30. International Nickel 371 10000 25.3 505 13000 16.8 International U t i l i t i e s 232 5000 12.7 435 11000 13.7 John Labatt P.CV 131 7500 255 12000 ' -John Labatt 136 10000 21.9 136 10000 15.8 Metro Stores 329 10000 23. 329 10000 19.7 Molsons 'A1 155 5500 17.8 282 10500 14.8 Molsons C CV 122 4500 - -Moore Corp. 305 15000 24. 7 618 24000 25.9 Bank of Nova Scotia 153 9000 20.2 16. 3 Oshawa Wholesale 'A' 90 2857 36.7 155 5000 30.27 Peel Elder 87 3750 34. 14.5 Power Corporation 57 5000 15. 278 22000 15.5 Rileys Datashare 142 10000 - 142 10000 -Royal Bank 163 10000 18.9 403 21000 15.9 Scottish & York Holdings 110 5000 25.4 110 5000 14.4 Shell O i l Canada 64 2775 19.6 350 12000 17.8 Continued Page 2 Page 2 -1969 STOCK VALUE SHARES Sh e r r i t t Gordon $ 156 15000 Sklar Mfg. 78 17000 Southam Press 50 6000 Spar Aerospace 49 10000 Steel Co. 532 20000 Texaco Canada 336 10000 Thompson Newspapers 423 30000 Union Gas 222 16500 Hiram Walker 238 7200 Western Broadcasting 218 10000 Zel l e r s Ltd. 95 15000 Inter P r o v i n c i a l Pipe 116 10350 6000 B e l l Telephone Bushnell Comm. 'A' Cdn. Steamship Lines Canadian P a c i f i c Railway Cdn. Superior O i l Canadian D i v e r s i f i e d Noranda Mines Placer Development Trans Canada Pipe Simpsons Ltd. Reed Shaw Osier Rapid Data Share Price Co. Ltd. Power Corp. Ltd. McMillan Bloedel Ltd. McLean Hunter Ltd. Leigh Instruments Hoilinger Mines Dominion Glass Co. Ltd. ESTIMATED AVERAGE P/ER - 1969 = 128 -P/ER 14.4 23.5 9.8 12.2 29. 3 24.1 14.6 28. 26.1 21. 14. 3 13. 15. 3 200. 16.1 22.7 33.5 27.6 15.3 15. 15.9 44.6 15. 17.6 29.20 ANNEX 8 B 4 cont 1d: 1970 VALUE SHARES P/ER 201 15000 9.5 78 17000 -415 7500 20.6 532 20000 17.5 336 10000 9.6 327 22000 27.6 135 10000 18.4 15. 25.7 25.2 237 12000 24.6 376 8000 12.8 220 10000 -150 5000 10.5 482 6000 11.5 430 10000 52. 171 20000 -188 6000 12.9 295 7500 22.8 162 4000 24. 3 382 21000 25.5 112 5000 -252 30000 -80 5000 29. 278 22000 15.5 119 3500 42. 340 19000 -331 13500 28.9 251 5000 12.4 212 15251 10500 14.9 ESTIMATED AVERAGE P/ER - 1970 = 28.10 - 129 - ANNEX 8 B 5 INVESTMENT PORTFOLIO OF COMPANY E - 1969-1970 1969 STOCK VALUE SHARES Bank of Commerce $ 1648 85000 Bpyal Bank 2628 129000 St. Lawrence Cement 293 12500 C I L 483 30200 Compute1 Systems 215 10000 Electr o n i c Ass. 33 1600 Crush International 705 60000 Seagrams 1030 20000 Harveys Foods 620 77500 John Labatt 1259 49400 George Weston 570 30000 McMillan Bloedel 1106 35000 Price Co. 393 28600 Weldwood 360 18500 Dominion Foundries 466 22200 Steel Co. 743 35000 Bombardier Ltd. 360 20000 ITL Industries 443 25000 Massey Ferguson 51 2800 Oshawa Wholesale 892 30000 Simpsons Ltd. 1332 72000 Zel l e r s 753 62800 Consol Morrison 244 40000 Alcan Aluminum 1630 55000 Bethlehem Copper 403 26000 Falconbridge Nickel 366 3000 International Nickel 638 15900 Noranda Mines 312 10000 Acqutaine Co. 263 12100 Dome Pete 265 3000 Home O i l Co. 1560 24000 Imperial O i l 1162 60000 Shell O i l Canada 443 16575 A l t a Gas 1655 40000 Trans Canada 1708 43800 West Coast Transmission 712 25000 1970 P/ER VALUE SHARES P/ER 14.9 $ 2601 13600 14.4 18.9 3131 15000 15.9 - 212 12500 11.6 11.1 12.8 22.3 509 49700 20. 15.5 1717 38600 14.6 29.8 70 59000 30. 21.9 767 34900 15.8 10. 1126 54300 15.4 15.9 673 28650 42. 15.3 803 109000 29. 11.2 226 18500 -10. 873 44800 8.5 9.8 894 42100 17.5 28. 245 20000 14. 3 38. 137 25000 58. 12.4 7.9 36.7 961 69900 30. 3 27.6 1370 87000 25.5 26.1 1262 140300 25.2 11.7 1348 62000 9.4 11.2 231 17000 10. 17. 1181 8400 14.5 25. 3 1173 29900 16. 8 16.1 1123 92000 12.9 34. 193 12100 28.8 30.8 440 10000 20.8 82. 115 332.5 19.2 28. 831 55000 26. 19.6 163 6450 17.8 16.6 1640 40000 17.1 33.5 24. 3 25. 3 138 8600 46. 8 Continued Page 2. Page 2 -STOCK Moore Corporation Southam Press Campeau Corporation Can. Int. Prop. Harding Carpets Canadian P a c i f i c Railway P a c i f i c Western A i r l i n e s B e l l Canada B.C. Telephone Consumers Gas International U t i l i t i e s Union Gas Capi t a l Bldg. Ind. Dominion Glass Famous Players Leigh Instruments Hiram Walker Canada Ti r e Inter Prov. Pipe Calgary Power Canadian Hydrocarbons Northern & Central Gas 1969 VALUE SHARES 4016 127500 781 12500 140 17000 19 4000 489 33750 3205 41500 287 20000 1402 30000 300 4275 467 27700 1195 39400 45 3200 286 4500 340 17000 435 41739 30000 ESTIMATED AVERAGE P/ER - 1969 = 30 - ANNEX 8 B 5 cont'd 1970 P/ER VALUE SHARES P/ER 24.7 $ 3697 127500 25.9 23.5 465 10000 20.6 28. 20. 38. 35. 21. 300 33750 21.9 15.3 2290 43600 11.5 28.3 172 21500 -14.3 2074 49400 12.8 13. 241 4275 12. 17.7 1710 11400 14.4 12.7 683 34400 13.7 15.3 19.2 17.6 178 17000 14.9 20. 110009 427 45000 13.4 44.6 408 34000 28.9 14.6 1328 33000 15. 27. 1178 62850 21. 21. 117 5550 24.6 14.3 583 27925 11.6 14.6 210 20000 10.5 22.4 430 38600 14.2 21.80 ESTIMATED AVERAGE P/ER - 1970 =17.0 o o 21 K O CJ H co i-3 K! X H O O cd > S • 1—1 h-1 I—1 H to to 1 T e c h n i c a l LO LO Fundamental 1—1 M H M 2 Dow Theory M H to h-1 to Volume Index 1—1 M I—1 H H H to Breadth Index H H H H M H H High/Low Index 1—1 to H H h-1 H to Short P o s i t i o n Index M to r-1 M H M Odd Lot Index M H H 1—1 H H Confidence Index H to LO to to I—1 H C h a r t i n g LO LO LO to *^  3 General Economic LO tt» LO its <u> >U F i n a n c i a l A n a l y s i s to LO LO to *» to LO P r i c e / E a r n i n g s R a t i o to LO to LO LO LO 4 P/ER I n f l u e n c e h-1 to LO to LO to 5 High P/ER D e s i r a b l e LO h-1 to M to to to 6 High P/ER O v e r p r i c e d to I—1 LO H to to to 7 Low P/ER f o r Income 4^  h-1 LO to M to to Low P/ER - C a p i t a l Gain to to to to to LO 8 Low P/ER U n d e s i r a b l e to to to to LO to to 9 P/ER-P/ER o f I n d i c e s I—1 I—1 h-1 H H 10 Markowitz Model M H LO LO - Return as P r o b a b i l i t y M 1—1 to H LO H LO 1 11 - R e l a t i v e Value Tech. Recommendations LO to LO to to LO LO Brokers LO to LO H to to LO C o u n s e l l i n g Firms w o t o CJ tr 1 i-3 CO O o c j H CO 3^ H O 21 3 12 Other LO 1 to 1 H I > 1 a 1 O 1 cn o CD d o < p» CD h-1 cn H cn M 0 ft) H H * J tr1 W O M O 3 M X co o - 132 -ANNEX 8 D RELATIVE PERFORMANCE OF TRUST COMPANY POOLED PENSION FUNDS COMPARED TO THE T.S.E. INDUSTRIAL AVERAGE INDEX DATE TSEIA Co. A Co. B Co. C Co. D Co. E Price Index Price Index Price Index Price Index Price Index Price Indej 1968 Jan. 158 100 18. 90 100 19. 79 100 13. 70 100 16. 70 100 20. 15 100 Feb. 149 95 18. 90 100 19. 00 96.5 12. 94 94 15. 97- 95 19. 69 96.5 Mar. 146 93 18. 90 100 18. 68 94 12. 60 92 15. 64" 92 19. 42 94.6 Apr. 160 101 18. 90 100 20. 68 104 14. 13 103 17. 65 104 21. 17 103 May 158 100 18. 90 100 20. 59 104 14. 04 102 17. 49 104 20. 95 102 Jun. 168 105 19. 83 105 21. 59 108 14. 94 109 19. 01 112 21. 54 105.] J u l . 165 104 20. 01 106 21. 31 107 14. 71 108 18. 87 111 21. 29 103.1 Aug. 169 107 19. 73 105 21. 68 109 14. 98 109 19. 60 116 21. 61 106.] Sep. 178 111 20. 36 108 22. 55 113 15. 53 114 20. 38 120 22. 68 I l l Oct. 181 113 20. 10 107 23. 19 116 15. 82 116 20. 98 124 22. 97 112 Nov. 187 118 20. 45 108 24. 02 120 16. 32 119 22. 16 130 24. 06 117 Dec. 190 119 20. 74 110 23. 77 119 16. 45 120 22. 28 131 23. 91 116 1969 Jan. 196 122 20. 36 108 10. 10 118 16. 65 122 22. 62 133 23. 45 114 Feb. 185 117 20 . 34 108 9. 71 112 16. 02 117 21. 65 128 22. 64 110 Mar. 191 120 20. 10 107 9. 98 117 16. 27 118 21. 72 128 23. 25 114 Apr. 197 123 20. 65 109 10. 09 118 16. 58 121 21. 74 128 23. 61 115 May 199 125 21. 23 112 10. 28 119 16. 95 124 22. 19 130 23. 93 116 Jun. 180 112 19. 90 106 9. 29 107 15. 17 111 19. 78 116 21. 94 106 J u l . 171 108 19. 32 102 8. 86 103 14. 44 104 18. 70 112 13. 15 104 Aug. 175 110 19. 73 104 9. 14 106 15. 07 110 19. 38 115 13. 62 108 Sep. 178 111 20. 11 107 9. 28 108 15. 23 112 19. 46 116 13. 56 108 Oct. 182 113 20 . 31 108 9. 37 109 15. 38 113 19. 89 119 13. 51 107 Nov. 185 . 117 20. 75 110 9. 69 113 15. 84 116 20. 56 121 13. 79 110 Dec. 184 117 20. 44 108 9. 50 111 15. 67 114 20. 41 120 13. 51 107 1970 Jan. 178 111 20. 18 107 9. 06 106 15. 20 111 19. 36 115 12. 92 102 Feb. 184 117 19. 99 106 9. 18 107 15. 34 112 19. 60 116 13. 03 103 Mar. 185 117 20. 08 107 9. 22 108 15. 39 112 19. 41 115 13. 04 103 Apr. 121 108 19. 32 102 8. 65 100 14. 07 103 17. 88 106 12. 04 95 May 154 97 16. 71 88 7. 75 90 12. 59 92 16. 13 97 10. 95 86 Jun. 151 95 16. 85 89 7. 65 89 12. 33 90 16. 06 96 10. 83 85 J u l . 157 99 16. 60 87 8: 00 93 12. 07 88 16. 66 100 11. 22 88 Aug. 160 100 16. 68 87 8. 21 96 13. 21 97 17. 01 102 11. 53 92 Sep. 165 104 17. 79 94 8. 43 98 13. 74 100 17. 77 106 11. 90 95 Oct. 167 106 17. 87 95 8. 24 97 13. 50 101 17. 41 103 11. 60 92 Nov. 169 107 17. 35 91 8. 52 99 13. 90 102 18. 16 109 12. 03 96 Dec. 174 110 18. 35 97 8. 79 103 14. 40 105 18. 92 111 12. 46 98 - 133 - ANNEX 8 E SUMMARY OF ANNUAL COMPOUND RATE OF RETURN (INCOME AND APPRECIATION) AND RELATIVE RANK. FOR POOLED EQUITY PENSION FUNDS ASSUMING UNIFORM MONTHLY CONTRIBUTIONS OF $1000 ENDING 31 MARCH, 1970 1 Yr. 3 Yrs. 5 Yrs. Y i e l d Rank Y i e l d Rank Y i e l d Ran] A 1.99 1 5.73 2 7.27 2 B -2.85 3 4.53 4 5.26 4 E -6. 32 5 -1.92 5 1.25 5 D -4.12 4 5.97 1 9.00 1 C 1.17 2 5.57 3 5.95 3 T.S.E. I.A. 5.70 8.48 +7.54 ENDING 30 JUNE, 1970 A -22.44 1 -5.66 1 0. 36 2 B -28.32 4 -8.70 4 -2.73 4 E -32.72 5 -14.47 5 -6.86 5 D .. -25.71 2 -7. 04 2 1.22 1 C -27.32 3 -8.44 3 -2.59 3 T.S.E. I.A. -22.42 -4.74 -0.29 ENDING 30 SEPTEMBER, 1970 A -6.79 4 -1.56 4 2.51 2 B -4.76 3 -1.38 3 1.66 4 E -7.68 5 -6.82 5 -2.54 5 D -3.09 1 0.72 1 4.93 1 C -3.93 2 -0.89 2 1.85 3 T.S.E. I.A. -2.95 1.48 3.39 - 134 -ANNEX 9 A MISCELLANEOUS DATA AND OTHER NOTHINGS (1) In 1969 we should observe the following data: Of 5 Trust Company P o r t f o l i o s -only 9 common stocks were held by a l l , only 6 common stocks were held by 4 of the 5, only 14 common stocks were held by 3 of the 5, only 26 common stocks were held by 2 of the 5. It w i l l be inte r e s t i n g to observe what, i f any, chang took place i n the common stocks that were held by a l l f i v e Trust Companies, and whether other common stocks had been added to thi s s e l e c t club. The common stocks held in a l l P o r t f o l i o s : TRUST COMPANY A B C D E Bank of Commerce * UP UP UP UP UP John Labatt Ltd. SAME UP SAME SAME DOWN D i s t i l l e r s Corp. UP UP DOWN UP UP International Nickel UP UP DOWN UP UP Moore Corporation UP UP SAME UP SAME Dominion Foundries SAME UP SAME UP UP Stelco SAME UP SAME SAME UP Consumers Gas UP UP DOWN UP DOWN International U t i l i t i e s DOWN UP UP UP SAME * Only Bank of Commerce was treated the same by a l l Companie Page 2 - - 135 -ANNEX 9 A cont' In 1970 four additional common stocks were added to this common to a l l club. They were: Falcoiabridge Nickel McMillan & Bloedel Canadian P a c i f i c Railway B e l l Canada. (2) The Price Earnings Ratios of the P o r t f o l i o s of the fi v e Trust Companies as at 31 December, 1969 and 31 December, 1970 were: 1969 A 12. 93 B 15. 32 C 17.83 D 29.20 E 21.80 TSE IA 16. 77 1970 14. 85 17.58 17.81 28.10 17.07 15.94 The rankings of these P o r t f o l i o s based on appreci ation shown i n Annex 8 C was: A B C D E TSE IA Dec/68 110 119 120 131 116 119 Dec/69 108 111 114 120 107 117 Dec/70 97 103 105 111 98 110 Ranking 1968 1969 1970 A 5 4 5 B 3 3 3 C 2 2 2 D 1 1 1 E 4 5 4 TSE IA (2) (2) (2) ANNEX 9 A Page 3 - - 136 - cont'd: NOTE: Companies D, C, B and the T.S.E. IA. held t h e i r positions and D, C and B had the highest P/ER - i n that order. D, although i t consistently ranked f i r s t i n t h i s schedule, was only .9% higher than the T.S.E. I.A. although D's P/ER was approximately 80% higher, or conversely the T.S.E. I.A. offered a 175% more income than did D for each d o l l a r invested. (3) When we consider ANNEX 8D showing the compound rate of return, the importance of timing over the long term becomes obvious. In the short run March 7,0 to September 70 rankings fluctuate rather v i o l e n t l y . But over the 5 year period they remain f a i r l y constant. Again we are reminded that the T.S.E. I.A. i s hard to beat. A new problem i s posed and that i s "How do we measure performance?" This question i s the subject of a whole new study. AN AFTERTHOUGHT The reader now has more information available concern-ing these f i v e Trust Company P o r t f o l i o s , t h e i r investment philos-ophy , decision making process and the performance of t h e i r funds than a Fi n a n c i a l Manager or Trustee of a pension fund could reasonably be expected to have. Into which fund would you place your companies' pension funds equity portion, i f indeed you would place your funds i n equities? 

Cite

Citation Scheme:

        

Citations by CSL (citeproc-js)

Usage Statistics

Share

Embed

Customize your widget with the following options, then copy and paste the code below into the HTML of your page to embed this item in your website.
                        
                            <div id="ubcOpenCollectionsWidgetDisplay">
                            <script id="ubcOpenCollectionsWidget"
                            src="{[{embed.src}]}"
                            data-item="{[{embed.item}]}"
                            data-collection="{[{embed.collection}]}"
                            data-metadata="{[{embed.showMetadata}]}"
                            data-width="{[{embed.width}]}"
                            async >
                            </script>
                            </div>
                        
                    
IIIF logo Our image viewer uses the IIIF 2.0 standard. To load this item in other compatible viewers, use this url:
http://iiif.library.ubc.ca/presentation/dsp.831.1-0101207/manifest

Comment

Related Items