NYT: Remembering a Classic Investing Theory

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August 15, 2007
Economic Scene
Remembering a Classic Investing Theory
By DAVID LEONHARDT

More than 70 years ago, two Columbia professors named Benjamin Graham and David L. Dodd came up with a simple investing idea that remains more influential than perhaps any other. In the wake of the stock market crash in 1929, they urged investors to focus on hard facts — like a company’s past earnings and the value of its assets — rather than trying to guess what the future would bring. A company with strong profits and a relatively low stock price was probably undervalued, they said.

Their classic 1934 textbook, “Security Analysis,” became the bible for what is now known as value investing. Warren E. Buffett took Mr. Graham’s course at Columbia Business School in the 1950s and, after working briefly for Mr. Graham’s investment firm, set out on his own to put the theories into practice. Mr. Buffett’s billions are just one part of the professors’ giant legacy.

Yet somehow, one of their big ideas about how to analyze stock prices has been almost entirely forgotten. The idea essentially reminds investors to focus on long-term trends and not to get caught up in the moment. Unfortunately, when you apply it to today’s stock market, you get even more nervous about what’s going on.

Most Wall Street analysts, of course, say there is nothing to be worried about, at least not beyond the mortgage market. In an effort to calm investors after the recent volatility, analysts have been arguing that stocks are not very expensive right now. The basis for this argument is the standard measure of the market: the price-to-earnings ratio.

It sounds like just the sort of thing the professors would have loved. In its most common form, the ratio is equal to a company’s stock price divided by its earnings per share over the last 12 months. You can skip the math, though, and simply remember that a P/E ratio tells you how much a stock costs relative to a company’s performance. The higher the ratio, the more expensive the stock is — and the stronger the argument that it won’t do very well going forward.
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http://www.nytimes.com/2007/08/15/business/15leonhardt.html