In March 2000, Cisco made the equipment connecting the Internet. Sysco delivered food to institutional kitchens. The names sounded similar; investors' expectations could hardly have differed more. Cisco cost two hundred nineteen times its annual earnings. Sysco cost about twenty-six times.
In his early-2000s commentary on Benjamin Graham's The Intelligent Investor, Jason Zweig follows the comparison through the collapse. Cisco's stock lost about three-quarters of its value from 2000 through 2002. Sysco's gained fifty-six percent. The comparison does not establish that food delivery beats technology. It exposes what a price can demand. A business may prosper while its shareholders receive little because they paid for that prosperity in advance.
Graham's answer combines an appraisal of what the business can conservatively earn or is worth with a price that allows for being wrong. Neither admiration nor apparent cheapness settles both.
What the price buys
The price-to-earnings ratio divides the share price by annual earnings per share. At twenty times earnings, the business earns five percent of your purchase price. That earnings yield is not a cash payment to you. Some earnings may become dividends; others remain in the company. Returns depend on those dividends, subsequent business growth and the multiple a future buyer pays. You cannot assume that enthusiasm will keep increasing.
Compare that uncertain claim with available high-grade bond income, recognizing that bondholders have contractual payments ahead of shareholders. And choose comparisons carefully. A stock is not cheap merely because another company's price is even harder to justify.
Even the earnings in the ratio need examination. A cyclical business can look cheapest at the top of a profit boom, precisely when those profits are least sustainable. Graham studies several years, including bad ones, to estimate normal earning power. Averaging reduces one year's distortion without making the future predictable.
Start with an understandable business. Find out what customers pay for, how much capital it needs and why competitors cannot easily take its profits. High returns attract rivals. Growth also requires resources, and sustaining an extraordinary growth rate becomes harder as a company expands. Buying other companies can increase reported revenue without improving the original operations. Cisco's recent growth included eleven acquisitions, giving buyers another reason to investigate what its impressive figures contained.
Follow the money through the accounts
Reported profit can rise without a comparable improvement in the business. Changing depreciation methods can reduce the expense charged against today's revenue. Optimistic pension-return assumptions can add accounting income without better operations. Read footnotes and compare years before accepting an improved profit figure. Costs repeatedly labeled exceptional still consume owners' money. Even Graham could not reconstruct a definitive earnings figure for ALCOA when its disclosures left the timing of major charges unclear.
Cash provides another check. Sales booked before customers pay may never be collected. If the seller lends customers the money to buy, it also takes the risk that they cannot repay. Rising revenue can coexist with a business repeatedly needing outside money to survive.
Zweig therefore examines owner earnings, the cash a business can produce after spending to maintain its operations. Equipment wears out. Adding back its accounting depreciation without allowing for replacement spending overstates what owners can take. Compare several years of cash flows with reported profit, rather than trusting either a single year's accounts or an optimistic forecast.
Debt brings another claim ahead of yours. Test whether earnings through adverse conditions can cover interest, and examine the cash and assets available if they cannot. Assets on the books need scrutiny too. An acquisition can leave a large accounting value for goodwill without a business able to earn enough to justify it. Conversely, a valuable brand may need few physical assets. Book value requires interpretation.
Finally, allow for shares that do not yet exist. Executive options and securities convertible into shares can spread future profits among more owners. That dilution makes today's earnings per share an incomplete picture of the claim you are buying.
Leave room for an imperfect answer
Use sustainable earnings and a multiple justified by their durability, growth prospects and financial risks to build an appraisal. Realizable assets and what a private owner would pay provide another approach. Keep the historical base separate from adjustments for future changes, so you can see how much rests on expectation. Elaborate arithmetic cannot make a weak assumption dependable.
Then require a margin of safety between that conservative appraisal and your price. Paying less leaves some room for the estimate to disappoint. For illustration, paying sixty dollars for conservatively estimated value of ninety follows Graham's historical bargain definition. That discount requires a credible appraisal; it is not a universal buying rule. Graham pairs this cushion with diversification across sound purchases, because individual judgments still fail. Owning many overpriced businesses cannot repair their prices.
His defensive screens combine financial strength, sustained earnings and dividends, and limits on price relative to earnings and assets. The historical thresholds are starting screens, not guarantees or universal rules. Utilities earn regulated revenues and finance themselves differently. Graham therefore exempts them from the industrial test of short-term assets against short-term obligations. Reports still need reading.
A weak company does not become attractive just by looking cheap. An excellent one can remain expensive for years. If you cannot establish a credible value or buy with sufficient protection, you can decline the purchase without forecasting a collapse. Admiration creates no obligation to own the shares.
Three things to keep
Business quality and purchase price must both make sense.
Reconstruct durable owner earnings before trusting an attractive earnings multiple.
A margin of safety allows for mistakes; it cannot eliminate them.