The Graham & Dodd P/E Matrix
Based on his observations of stock over the years, Benjamin Graham developed a stock valuation model that allows for future growth. Graham observed that the average no-growth stock sold at 8.5 times earnings, and that price-earnings ratios increased by twice the rate of earnings growth. This led to the earnings multiplier:

P/E = 8.5 + 2G

where G is the rate of earnings growth, stated as a percentage.

The original formulation was made at a time when there was very little inflation, and growth could be assumed to be real growth; the AAA corporate bond interest rate prevailing at the time was 4.4%. In later years, the formula was adjusted for higher current interest rates that contained an inflationary component:

P/E = [8.5 + 2G] 4.4/Y

where Y is the current yield on AAA corporate bonds.

As an example, at a 6% bond yield and an assumed annual earnings growth rate of 10%, the P/E multiplier would be:

P/E = [8.5 + 2(10)] 4.4/6
       = 28.5 0.73
       = 20.9

The Graham and Dodd P/E Matrix uses this valuation formula to show the price-earnings ratio that results from a given bond yield at a given rate of earnings growth. You can see from the table that changes in interest rates will have a dramatic effect on price-earnings ratios for any given earnings growth rate.
 


 

Graham & Dodd P/E Matrix
Bond Yield Expected 5-Year Annual Growth Rate:
0% 5% 10% 15% 20% 25% 30% 35% 40%
1% 37.4 81.4 125.4 169.4 213.4 257.4 301.4 345.1 389.4
2% 18.7 40.7 62.7 84.7 106.7 128.7 150.7 172.7 194.7
3% 12.5 27.1 41.8 56.5 71.1 85.8 100.5 115.1 129.8
4% 9.4 20.4 31.4 42.4 53.4 64.4 75.4 86.4 97.4
5% 7.5 16.3 25.1 33.9 42.7 51.5 60.3 69.1 77.9
6% 6.2 13.6 20.9 28.2 35.6 42.9 50.2 57.6 64.9
7% 5.3 11.6 17.9 24.2 30.5 36.8 43.1 49.3 55.6
8% 4.7 10.2 15.7 21.2 26.7 32.2 37.7 43.2 48.7
9% 4.2 9.0 13.9 18.8 23.7 28.6 33.5 38.4 43.3
10% 3.7 8.1 12.5 16.9 21.3 25.7 30.1 34.5 38.9
11% 3.4 7.4 11.4 15.4 19.4 23.4 27.4 31.4 35.4
12% 3.1 6.8 10.5 14.1 17.8 21.5 25.1 28.8 32.5
13% 2.9 6.3 9.6 13.0 16.4 19.8 23.2 26.6 30.0
14% 2.7 5.8 9.0 12.1 15.2 18.4 21.5 24.7 27.8
15% 2.5 5.4 8.4 11.3 14.2 17.2 20.1 23.0 26.0
16% 2.3 5.1 7.8 10.6 13.3 16.1 18.8 21.6 24.3
17% 2.2 4.8 7.4 10.0 12.6 15.1 17.7 20.3 22.9
18% 2.1 4.5 7.0 9.4 11.9 14.3 16.7 19.2 21.6
19% 2.0 4.3 6.6 8.9 11.2 13.5 15.9 18.2 20.5
20% 1.9 4.1 6.3 8.5 10.7 12.9 15.1 17.3 19.5