| The Graham & Dodd P/E Matrix |
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| 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/Ywhere 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 |