CFA Institute

Compound Interest and Annuity Tables: And Their Use in Equity Valuation and Portfolio
Management
Author(s): W. Edward Bell
Source: Financial Analysts Journal, Vol. 20, No. 3 (May - Jun., 1964), pp. 111-117
Published by: CFA Institute
Stable URL: http://www.jstor.org/stable/4469659 .
Accessed: 17/06/2014 01:48

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .
http://www.jstor.org/page/info/about/policies/terms.jsp

.
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of
content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms
of scholarship. For more information about JSTOR, please contact support@jstor.org.

CFA Institute is collaborating with JSTOR to digitize, preserve and extend access to Financial Analysts
Journal.

http://www.jstor.org

This content downloaded from 91.229.248.187 on Tue, 17 Jun 2014 01:48:05 AM

All use subject to JSTOR Terms and Conditions
 COMPOUND INTEREST
and their use in
Equity Valuation and
by W. Edward Bell
THIS ARTICLE will be of interestprimarilyto financial
analystswho have not becomefully accustomedto
the use of compoundinterest and annuitytables.
Some of the illustrationsmay also interest more ex-
periencedanalysts. Whileintroductoryand by no means
exhaustive, the presentationshould assist readers in
acquiringa fullergraspof the characteristicsof standard
tables and facilityin their use.
For convenientreference,we include a set of con-
densedtables (see page 113). These are most detailed
for the compound amount function (Table A). The
compound amount is shown for twelve rates ranging
from 21/2% to 25 %; for many purposesintermediate
values derivedby interpolationwill be sufficientlyaccu-
rate. While the present value and annuity functions
(Tables B, C and D) are much more condensed,other
values can be readilydeterminedfrom Table A with a
calculatoror slide rule. For our purposestablesto four
or five significantfiguresare adequate. Where precise
computationsare required,as in settling an obligation,
tables to more decimalplaces should be used. (Copies
of the condensedtablesmay be obtainedfromthe writer
on request.)
The values shown for the presentvalue and annuity
functions were selected as those especially useful in
some approachesto comparativeequity valuation. A
very brief introductionto this subjectis includedin the
present article. The writer is preparinga somewhat
fuller treatmentof equity valuationwhich will appear
in an early issue of the Financial Analysts Journal.
Compound Amount of 1-(Table A)
Nearly everyone is familiar with the compoundin-
terest table. This shows the value which $1.00 will
become after n years (time periods) with interest at
W. Edward Bell is a vice president of Crocker-Citizens
National Bank and is president of The Security Analysts
of San Francisco. He is coordinator of a course in Invest-
ment Analysis and Management jointly sponsored by the
San Francisco society and University of California. He is
author of "The Price-Future Earnings Ratio," Financial
Analysts Journal, August 1958. Mr. Bell has an M.B.A.
degree from Stanford University and is a Chartered
Financial Analyst.
MAY-JUNE 1964
This content downloaded from 91.229.248.187 on Tue, 17 Jun 2014 01:48:05 AM
All use subject to JSTOR Terms and Conditions
AND ANNUITY TABLE
Portfolio Management
rate i addedat the end of each year. If interestis com-
pounded annuallyat 5%, the value at the end of one
year is $1.00 times 1.05; at the end of the second year
the value or compoundamountis $1.00(1.05)(1.05).
The generalized formula is (1 + i) n, where i is the
interestrate per period and n is the numberof periods.
Since the initialsum is rarely$1.00, we simplymultiply
the initial amount by the appropriatefactor shown in
the table. Thus, $10,000 investedfor five years at 5%
compoundedannuallywill be worth $10,000 (1.2763)
or about$12,763 at the end of five years. We will later
illustratehow our condensedTable A can be used for
time periodsnot shown, such as 18 years or 75 years.
For interestrates not shown one can interpolateif an
approximationis adequate;otherwiseone must refer to
detailedtables, use a log-log slide rule at some expense
of precision,or use logarithms.
EXAMPLE 1. Mr. Smithestablishesa $5,000 educa-
tional fund for his five-year-oldgrandson. Income will
be reinvested. What will be the value of the fund in
12 years, assumingan averagereturnof 6% including
both incomeand appreciation?
Solution. TableA showsthat $1.00 compoundedfor
12 years at 6% will become $2.0122; $5,000 will be-
come $5,000(2.0122) or $10,061. This could be
roundedto $10,000.
EXAMPLE 2. After 12 years the initial $5,000 fund
in Example1 has increasedto $13,750. Whathas been
the averageannual return,includingboth income and
appreciation?
Solution. Divide $13,750 by $5,000; the quotientis
2.75. Reading horizontallyin Table A from n 12,
you find that 2.75 falls between2.5182 (for 8%) and
2.8127 (for 9% ) andis muchcloserto the latter. Thus,
the averageannualreturnwas just under9%. (As we
will illustrate,Table B could also be used.)
EXAMPLE 3. In negotiatingthe sale of a privatecom-
pany, you are offered the alternativeof $50,000 cash
now or $70,000 cash to be paid withoutinterestin five
years. You decide to take the cash now unless the
deferredpaymentoffers a returnof 8% or better.
Solution. Divide 70 by 50; the quotientis 1.40. From
111
Table A you find that the returnis just under7%. The
deferredpaymentis rejected.
EXAMPLE 4. What will be the value in 18 years of
$10,000 investedat an averagereturnof 6%?
Solution. Our condensed Table A does not show
values for n - 18. But consider that (1.06)18
(1.06)15(1.06)3. Thus, we have 2.3966(1.1910)
2.8543506. We should roundthis to 2.8544, since our
table values are to five significantfigures. The answer
is $28,544.
EXAMPLE 5. A company states that total industry
sales of their majorproductshould grow at about 7%
per year for at least five years; also that the company's
shareshouldincreasefrom 15% to 18% of the industry
in the five years. The industry'ssales of the productare
now $3,000 million. What will the industry'ssales be
in five years? What will the company's sales of the
productbe? What rate of growthof companysales is
implied?
Solution. In five yearsindustrysales wouldbe $3,000-
(1.4026) millionor $4,208 million. At 18% the com-
pany'ssharewould be $757 million. Companysales of
the productare now $450 million. The impliedgrowth
rate for companysales is about 11% per year. (This
could be computedmore preciselywith the log-log slide
rule if any useful purposeis served.)
EXAMPLE 6. As an exercisein imagination,consider
$1,000 investedat 5% compoundedfor 175 years.This
can be reducedto
$1,000 (1.05) 50 (1.05) 50 (1.05)30 (1.05) 25,
and to (from Table A)
$1,000 (11.467) 3 (3.3864)
The answeris approximately$5,106,000. Another 50
years (225 years in all) would bringthe initial $1,000
to nearly $59 million. In 500 years at 5%, $1,000
would exceed $39 trillion! This may suggest why we
have laws againstperpetuities. Consideralso the very
rapid compounding at high rates such as 10% or
above. It is evident that one must use caution in pro-
jectinghigh growthratesfor very many years.
Present Value of 1-(Table B)
Presentvalue tables converta futuresum to its pres-
ent value on the basis of a given rate of discount
(interest) per year (time period) and a given number
of years.Compounddiscountis analogousto compound
interest.
If a presentsum of $1,000 is worth $1,000(1.4775)
or about$1,478 in eightyearsat 5% compoundinterest
(Table A), it follows that $1,478 due in eight years is
now worth $1,000, discounted at 5%. Referring to
Table B, we have $1,478(.6768), or about $1,000.
Note the reciprocalor inverse relation between the
formulasandvaluesfor TablesA andB. Missingvalues
in Table B can be quickly determinedby dividingthe
correspondingTable A value into 1. More directly,
Table A values can always be substitutedfor Table B
by dividinginsteadof multiplying.
112
This content downloaded from 91.229.248.187 on Tue, 17 Jun 2014 01:48:05 AM
All use subject to JSTOR Terms and Conditions
EXAMPLE 7. A client plans to set up a fund for the
college expensesof her grandchildren.The objectiveis
a fund of about $25,000 in 15 years. Net income will
be reinvested. If you assumean averageannualreturn
of 7%, includingboth income and appreciation,what
initial amountis required?
Solution. Table B shows that the present value of
$1.00 in 15 years at 7% compoundinterest(discount)
is $0.3624. The required present fund is $25,000
(.3624), or just under $9,100.
EXAMPLE 8. Miss Foster has expert advice that her
tract of unimprovedland should be worth at least
$75,000 in 10 years. The best currentofferis $20,000.
Should she sell?
Solution. Divide 20 by 75 to determinethe discount
factorfor Table B; the quotientis about .267; since this
does not appearfor n - 10 in our condensedTable B,
we may take the reciprocalof .267 (or 1/267); more
directly, divide 75 by 20. The compound amount
(Table A) factor is 3.75. For n_ 10 this indicatesa
returnof about 14%. The decisionas to whetheror not
to sell the real propertywould also dependon taxes and
other costs, alternativeinvestmentsavailable(including
the level of stock prices), the reliabilityattributedto the
projectedvalue of the property,considerationsof tem-
peramentand preference,and so forth.
As we have indicated,Examples2 and 3 can also be
solved using the discounttable (B); in both cases the
presentvalue wouldbe dividedbv the futurevalue. The
present value is the base or divisor in compounding
(Table A); the future value is the base or divisor in
discounting(Table B). We have seen that the com-
pound amount factor can be used for discountingby
invertingthe fraction.
Amount of an Annuity of 1 per Period
Present Value of an Annuity of 1 per Period
(Tables C and D)
The annuityconceptis somewhatmore complexthan
compoundingand discounting.The formulas,shown at
the top of Tables C and D, are developedin any text-
book on the mathematicsof finance. First, we will
definethese concepts.
The amount(or sum) of an annuity(Table C) is the
value at the end of n years (time periods) of a series of
equalpaymentsmadeat the end of each year,with com-
pound interestat rate i accumulatedfrom the time of
each paymentto the terminaldate.
The present value of an annuity (Table D) is the
value at the beginningof n years (time periods) of a
series of equal paymentsmade at the end of each year,
with each payment discountedto its present value at
compoundrate of interest(discount) i.
We shall be concernedwith time periods of one or
more full years and with interestcompoundedannually.
This article will not cover problems involving com-
poundingintervalsdifferentfrom the payment period
nor with annuitiesdue, in which the paymentis made
FINANCIAL ANALYSTS JOURNAL
 INTERESTAND ANNUITYTABLES
COMPOUND
CONDENSED

Table A
Compound Amount of 1: (1 + i)

n 2?7% 4%. 5% 6% 7% 87.j 9% 10 71 15%- 207. 257

1 1.0250 1.0400 1.0500 1.0600 1.0700 1.0800 1.0900 1.1000 1.1250 1.1500 1.2000 1.2500
2 1.0506 1.0816 1.1025 1.1236 1.1449 1.1664 1.1881 1.2100 1.2656 1.3225 1.4400 1.5625
3 1.0769 1.1249 1.1576 1.1910 1.2250 1.2597 1.2950 1.3310 1.4238 1.5209 1.7280 1.9531
4 1.1038 1.1699 1.2155 1.2625 1.3108 1.3605 1.4116 1.4641 1.6018 1.7490 2.0736 2.4414
5 1.1314 1.2167 1.2763 1.3382 1.4026 1.4693 1.5386 1.6105 1.8020 2.0114 2.4883 3.0518

6 1.1597 1.2653 1.3401 1.4185 1.5007 1.5869 1.6771 1.7716 2.0273 2.3131 2.9860 3.8147
7 1.1887 1.3159 1.4071 1.5036 1.6058 1.7138 1.8280 1.9487 2.2807 2.6600 3.5832 4.7684
8 1.2184 1.3686 1.4775 1.5938 1.7182 1.8509 1.9926 2.1436 2.5658 3.0590 4.2998 5.9605
9 1.2489 1.4233 1.5513 1.6895 1.8385 1.9990 2.1719 2.3579 2.8865 3.5179 5.1598 7.4506
10 1.2801 1.4802 1.6289 1.7908 1.9672 2. 1589 2.3674 2.5937 3.2473 4.0456 6.1917 9.3132

11 1.3121 1.5395 1.7103 1.8983 2.1049 2.3316 2.5804 2.8531 3.6532 4.6524 7.4301 11.642
12 1.3449 1.6010 1.7959 2.0122 2.2522 2.5182 2.8127 3.1384 4.1099 5.3503 8.9161 14.552
15 1.4483 1.8009 2.0789 2.3966 2.7590 3.1722 3.6425 4.1772 5.8518 8. 1371 15.407 28.422
20 1.6386 2. 1911 2.6533 3.2071 3. 8697 4. 6610 5.6044 6.7275 10.545 16.366 38.338 86. 736
25 1.8539 2.6658 3.3864 4.2919 5.4274 6.8485 8.6231 10. 835 19.003 32.919 95.396 264.70

30 2.0976 3.2434 4.3219 5.7435 7.6123 10.063 13.268 17.449 34.243 66.212 237.38
35 2.3732 3.9461 5.5160 7.6861 10.677 14.785 20.414 28.102 61.708 133.18
40 2.6851 4.8010 7.0400 10.286 14.974 21.725 31.409 45.259 111.20
45 3.0379 5.8412 8.9850 13.765 21.002 31.920 48.327 72.890
50 3.4371 7.1067 11.467 18.420 29.457 46.902 74.358 117.39

Table B v Table C- snl Sum or Table D-Lnn

Present Value of 1 Amount of Annuity of 1 Present Value of Annuity of 1
n (1+ )n = 1 = (1+i)_ -1 oR = 1- (+i)

n 57. 6% 77. 87. 5% 6% 7% 8% 5%7 6% 7% 87

5 .7835 .7473 .7130 .6806 5.526 5.637 5.751 5.867 4.329 4.212 4.100 3.993
6 .7462 .7050 .6663 .6302 6. 802 6.975 7.153 7.336 5.076 4.917 4.767 4.623
7 .7107 .6651 .6227 .5835 8.142 8.394 8.654 8.923 5.786 5.582 5.389 5.206
8 .6768 .6274 .5820 .5403 9.549 9.897 10.26 10.64 6.463 6.210 5.971 5.747
9 .6446 .5919 .5439 .5002 11.03 11.49 11.98 12.49 7.108 6.802 6.515 6.247

10 .6139 .5584 .5083 .4632 12.58 13.18 13.82 14.49 7.722 7.360 7.024 6.710
11 .5847 .5268 .4751 .4289 14.21 14.97 15.78 16.65 8.306 7.887 7.499 7.139
12 . 5568 .4970 .4440 .3971 15.92 16.87 17. 89 18.98 8.863 8.384 7.943 7. 536
15 .4810 .4173 .3624 .3152 21.58 23.20 25. 13 27. 15 10.38 9. 712 9.108 8.559
20 . 3769 . 3118 . 2584 . 2145 33.07 36. 79 41. 00 45. 76 12.46 11. 47 10. 59 9. 818
25 .2953 .2330 .1842 .1460 47.73 54.86 63.25 73.11 14.09 12.78 11.65 10.67

M!AY-JUNE 1964 113

This content downloaded from 91.229.248.187 on Tue, 17 Jun 2014 01:48:05 AM

All use subject to JSTOR Terms and Conditions
at the beginning of each interval. These special cases
are covered in standard textbooks.
An illustration will clarify the nature of the amount
(or sum) of an annuity (Table C):
AmountAdded Total Addition
to Fundat InterestEarned to Fundfor Valueof Fund
Endof Year on Total Fund the Year at Endof Year
1st year $10,000 None $10,000
2nd year 10,000 $ 500 10,500
3rd year 10,000 1,025 11,025
4th year 10,000 1,576 11,576
5th year 10,000 2,155 12,155
In Table C note the amount of an annuity (value on
terminal date) of $1.00 per year for five years at 5%;
this is $5.526. For $10,000 the amount is $55,260 (to
four significant figures). This is the same as the value
obtained in the above table, with the $4 discrepancy due
to rounding.
We may arrive at the same value by following the
process suggested by our definition of the sum of an
annuity; note that the final column of the following table
is the inverse of the next to last column of the preceding
table.
PeriodFromEach$10,000 Compound Amount Valueof Payment
Paymentto Final Date of 1 (TableA) at Final Date
4 years 1.2155 $12,155
3 years 1.1576
2 years 1.1025
1 year 1.0500
None (paid on final date) (1.0000)
$55,256
The direct relation between the amount and the
present value of an annuity is given by the compound
amount or discount (Table A or B). Thus, the amount
(terminal value) $55,256 in the above example has a
present value, discounted at 5%, of $55,256(.7835),
or $43,293. Using Table D to obtain this directly, we
find that the present value of an annuity of 1 for five
years at 5% is $4.329; for an annuity of $10,000 per
year, this would be about $43,290, the same figure
except for rounding.
Upon reflection you will recognize that by definition
Table D is the product of Tables B and C, or is Table C
divided by Table A. You will perceive this relationship
in the formulas shown with each table.
EXAMPLE9. A client is planning an educational fund
for his children. Income will be reinvested. (a) If $500
new money is added to the fund each year, how much
will be available in 15 years, assuming a 6% return?
(b) How much must be set aside annually at 6% to
accumulate $15,000 in 15 years? (c) If he can place
$5,000 in the fund at this time, how much must be set
aside annually to accumulate $25,000 in 15 years? In
the latter case, assume a return of 7 % on the initial
sum but only 6% on the annual additions and on re-
invested income from the annuity portion.
Solution. (a) In Table C, note that the amount
(accumulated final value) of an annuity of $1.00 at the
end of each year for 15 years at 6% is $23.28; $500
(23.28) is $11,640, the approximate amount available
in 15 years. (b) Using the same factor from Table C,
again consider that for each $1.00 set aside at the end
of each year there will be a final value (at a 6% return)
of $23.28. Dividing the desired final sum of $15,000
by 23.28, we find that the annual requirement is about
$644. This can also be derived from (a), as follows:
$10,000
20,500 15,000 x
31,525 and X = $644
43,101 11,640 500
55,256
(c) Use Tables A and C. The initial $5,000 will be-
come $5,000(2.7590), or $13,795. This leaves $11,205
of the desired $25,000 to be obtained from annual addi-
tion of new funds. Dividing $11,205 by 23.28 gives the
required annual amount of about $481.
EXAMPLE 10. Mrs. Berg, age 65, has received
$100,000 from her husband's life insurance. She states
that she needs $8,000 per year to maintain her accus-
tomed standard of living. (a) How long will her capital
last if she spends $8,000 per year, assuming an average
return of 6% (including appreciation of equities and
net of costs)? (b) Assuming a 6% return, how much
can she spend each year from income and principal, if
capital will not be exhausted for 35 years, or before
11,576 age 100?
11,025 Solution. (a) Divide $100,000 present value by the
10,500
10,000 $8,000 desired annuity; the quotient is 12.5. Under 6%
in Table D we find that 12.5 falls between 11.47 (for
20 years) and 12.78 (for 25 years). We estimate that at
a 6% net return Mrs. Berg's capital would be exhausted
in about 24 years, or at age 89. Unusual longevity, a
lower return, unfavorable market developments, or poor
investment management would jeopardize her future
security. (b) Our condensed Table D does not cover
35 years. If detailed annuity tables are not available, we
may use Table A by substituting the compound amount
factor in the formula for the present value of an annuity
(see Table D). First, recall that 1.06-'s means 1/1.06n.
Table A shows that the compound amount of $1.00 at
6% for 35 years is $7.6861. Using a slide rule or calcu-
lator, we find that 1/7.6861 is about .13; 1 minus .13 is
.87; .87 divided by .06 is about 14.5. Dividing $100,000
by 14.5 we find that Mrs. Berg could spend about
$6,900 per year.
Approximation Without Tables
In conferring with clients the investment advisor will
occasionally wish to make rough annuity estimates with-
out tables. (We would observe that precise mathematical
calculations have no special merit in making such future
projections, especially where equity investments are
concerned.) Using Mrs. Berg as an example, note that
her fund will be $50,000 when one-half exhausted. The
average return at 6% on average capital of $50,000 is
$3,000; this leaves $5,000 of the $8,000 annual require-
ment in (a) to be obtained from principal. On this basis
the $100,000 fund would last about 20 years. Our
previous calculation indicated about 24 years. In (b)

114 FINANCIAL ANALYSTS JOURNAL.

This content downloaded from 91.229.248.187 on Tue, 17 Jun 2014 01:48:05 AM

All use subject to JSTOR Terms and Conditions
we assumed exhaustionof capital in 35 years. Mrs.
Berg could spend annually 1/35 of her initial capital
plus $3,000 averageincome;this is about $2,857 plus
$3,000 or $5,857 per year. Our computedamountwas
about $6,900. Such approximationswill vary in reli-
ability,dependingon the rate of returnand time period.
Mathematically,the average investment is actually
greaterthan half the initial principal,and the average
principalencroachmentto provide a given annual re-
quirementis less than that derived by approximation
withouttables.
EXAMPLE 11. Your advice is sought in connection
with a propertysettlementfor Mrs. Gray. Settlement
will be cash and will be invested in bonds and stocks.
All parties agree to assumea 5% return,includingin-
come and appreciationand net of costs. Mrs. Gray is
to receive $5,000 per year for 25 years. After 25 years
(or on Mrs. Gray'sdeath, if earlier), any balance will
revertto the settloror his heirs. (a) What initial fund
is required? (b) On the assumptions,how much would
remainat the end of 10 years? (c) Discountingat 5%,
whatis the presentvalueof the amountwhichwill revert
to the settlor if Mrs. Gray lives just 10 years? In this
case, what is the net cost to the settlor?
Solution. (a) Table D gives $14.09 as the present
value of an annuity of $ 1.00 at 5 % for 25 years.
The requiredinitial fund is $5,000(14.09), or about
$70,450. (If precisionis desired,tablesto more decimal
places should be used.) (b) The projectedremaining
fund after 10 years can be developedin several ways.
(1) We may use Table A to project the value of
$70,450 at 5% in 10 years; then use Table C to de-
terminethe amountof an annuityof $5,000 at 5% for
10 years; subtractingwe find the estimatedremaining
fund to be about $51,856. (2) Alternatively,we may
subtractthe present value of an annuityof $5,000 at
5% for 10 years (Table D) from the initial amountof
$70,450; then use Table A to projectthis value for 10
years. With our condensedtables we get a projected
value of $51,864, with the slight difference due to
rounding. (c) We have found that the value of the
fund remainingin 10 years will be about $51,860; dis-
counted at 5% to its present value we have $51,860-
(.6139), or about $31,837. Thus, the net cost to the
settlor if Mrs. Gray lives just 10 years is $70,450 less
$31,837, or about $38,613.
Estimating the Total of a Growing
Series of Earnings or Dividends
We now considerthe problemof estimatingthe total
of a series of periodic figures growing at an assumed
constantrate. A typical exampleis annualearningsor
dividends per share. Projection of total earnings or
dividendsfor a period of years is often useful in con-
sideringthe relativeattractionof alternativeinvestments.
Many analystsfeel that it is difficultenough to pre-
dict earningssix monthsin the future,let alone five or
ten years. In our view a distinctionshould be made
between a predictionand a projection. Investmentde-
MAY-JUNE 1964
This content downloaded from 91.229.248.187 on Tue, 17 Jun 2014 01:48:05 AM
All use subject to JSTOR Terms and Conditions
cisions involve implicitassumptionswith respectto the
long as well as the short term future. The analyst's
judgmentis sharpenedby the effort of expressinghis
conceptof a company'sprospectsin quantitativeterms.
We will firstshow how the total of a growingseries can
be readilyprojected. We will then use this tool in one
of our approachesto comparativeequityvaluation.
Refer now to the five-year illustrativetable at the
beginningof our discussionof annuitiesand Tables C
and D. The next to the last column ($10,000 to
$12,155) is a typical series growingat a constantrate,
in this instance at 5% per year. Note that the final
column ($10,000 to $55,256) is the cumulativetotal of
the entriesin the precedingcolumn down to any year.
In terms of an annuityof 1, the amountof an annuity
at 5% for five periodsis 5.526; this is also the total of
a seriesof five annualpaymentsbeginningat $1.00 and
growingat 5% compoundedper year. Thus, the table
or formulafor the amount of an annuity (see top of
Table C) may be used to determinethe total of a series
(such as earningsor dividends) growingat annualrate
i for n years.
EXAMPLE 12. If a company's current dividend is
$4.00 per shareand a growthrate of 7% is anticipated
for a decadeor more,what are projectedtotal dividends
for the next 10 years?
Solution. Table C gives 13.82 as the amount (sum)
of an annuityof 1 at 7% for 10 years. Total projected
dividendsfor 10 years are $4.00(13.82), or $55.28.
EXAMPLE 13. Present dividend rate is $5.00; as-
sumed growthrate is 4%. Project total dividendsfor
the next five years.
Solution. Our condensed Table C does not show
4%; derivethe requiredfactorfrom Table A, using the
formulashown with Table C. Note that the compound
amountof 1 at 4% for five years is 1.2167; subtract1
and divideby .04; the amountof annuityfactoris about
5.42. Total dividendsare projectedat $5.00(5.42), or
about $27.
Comparative Equity Valuation
The valueof a commonstock reflectspast and current
earningsand dividends,qualityand other characteristics
as identified from the past record, and, particularly,
futureprospects. Estimatesof future prospectsusually
reflectthe past recordto a considerabledegree,but the
analystmust also considermany factorsnot susceptible
of measurementand requiringthe exerciseof judgment.
Because the subjective element is substantial, many
analysts prefer not to attempt to evaluate equities in
quantitativeterms. As we have stated, our position is
that projections(not forecasts) on a quantitativebasis
are implicitin investmentdecisions and that the effort
to formulatespecificprojectionsof future earningsand
dividendsas a basis for comparativevaluationwill, on
the whole, lead to morereliablejudgments.
We will use the following table as the basis for an
introductorydiscussionof comparativeequityvaluation.
115
In including the Dow-Jones Industrial Average our pur- subjectivemanner,the analyst is alerted to review his
pose is illustrative; we intend no implication with respect thinkingwith care.
to its current value.
The Price-Future Earnings Ratio
Dow-Jones Stock Stock Stock Stock Stock
Industrials No. 1 No. 2 No. 3 No. 4 No. 5 The price-futureearningsratio is simply the payout
Market price 800 60 63 72 87 114 period,or the numberof years requiredto amortizethe
Current earn. 44 3.00 3.00 3.00 3.00 3.00 market price out of the flow of rising earnings. The
Dividend rate 24 2.40 2.00 1.60 1.40 1.00 writer discussed this approachin some detail in the
Payout 55% 80% 670/c 53% 47%l 33%o
P/E ratio 18.2 20 21 24 29 38 August 1958 issue of The FinancialAnalysts Journal.
Yield 3.0%l 4.0%cc 3.2/cl 2.2% 1.6% .9% We presentbelow a portionof the table includedin that
Proj. growth 4%cl 4 1/4 5cC, 7%T 9% 121/2% article. Fromthe discussionprecedingour examples12
and 13 the derivationof the table from the formulafor
EXAMPLE 14. Our first approach to valuation illus- the amountof an annuityis evident.
trates a conservative and widely used technique: the
current market is related to projected earnings in five
Using the annuityformula,if x is the price-earnings
ratio, n the price-futureearningsratio, and i the as-
years. The compound amount factor for each assumed
growth rate is applied to current earnings. If earnings
sumed constant annual rate of growthof earningsper
are abnormally high or low for temporary or non-recur-
share,then
ring reasons, they may be adjusted as a basis for pro- (1 + i)n-1 log (ix + 1)
jection. Since the remaining examples are all based on x= and n=
the above tabulation, we omit column headings. i log (1 + i)

Proj. earnings in 5 yrs. 531/2 3.65 3.83 4.21 4.62 5.41 Price-future earnings ratio
Market/projected earn. 15.0 16.4 16.4 17.1 18.8 21.1 Price-
earnings Estimated annual growth of earnings
Whereas the six price-earnings ratios based on cur- ratio 3%clo 5 % 7 % 10 % 12 %/G 15 % 20%/o
rent earnings range from 18.2 to 38, the ratios to pro- 12 10.4 9.6 9.0 8.3 7.9 7.4 6.7
jected earnings in five years fall in the considerably 14 11.9 10.9 10.1 9.2 8.7 8.1 7.3
narrower range of 15.0 to 21.1. However, in all but one 16 13.3 12.0 11.1 10.0 9.5 8.8 7.9
case the higher ratios are still associated with superior 18 14.6 13.2 12.1 10.8 10.2 9.4 8.4
20 15.9 14.2 12.9 11.5 10.8 9.9 8.8
growth prospects. Obviously the market places a greater
premium on superior growth than that implied by the 22 17.1 15.2 13.8 12.2 11.4 10.4 9.2
ratio of price to earnings in five years (our hypothetical 24 18.3 16.2 14.6 12.8 12.0 10.9 9.6
26 19.5 17.1 15.3 13.4 12.5 11.4 10.0
stocks are fairly typical of present market conditions). 28 17.9 16.0 14.0 13.0 11.8 10.4
Nonetheless, value comparisons are facilitated, and the 30 18.8 16.7 14.5 13.5 12.2 10.7
approach has the advantage of encouraging very con- 32 19.6 17.4 15.1 13.9 12.6 11.0
servative premiums for superior future expectations, at 34 18.0 15.5 14.3 12.9 11.3
best uncertain. However, when growth projections are 36 18.6 16.0 14.7 13.3 11.5
well founded and made with caution, we consider pro- 40 19.7 16.9 15.5 13.9 12.1
jected earnings in five years an unnecessarily conserva- 50 18.8 17.2 15.3 13.2
75 22.5 20.3 17.9 15.2
tive basis for the comparison of values.
EXAMPLE 15. We may use the same approach with EXAMPLE 16. Applying the price-futureearnings
earnings projected seven years instead of five. The ratio to our examples,we have:
longer projection, of course, places greater importance P/E ratio 18.2 20 21 24 29 38
on the reliability of our growth estimates. Growth rate 4% 4% 5% 7% 9% 121/2%
Proj. earnings in 7 yrs. 58 3.95 4.22 4.82 P/FE ratio 14 15 143/4 14'/2 15 15
5.48 6.84
Market/projected earn. 13.8 15.2 14.9 14.9 15.9 16.7 Except for very high growth rates, the price-future
The ratios of market to projected earnings now fall in earningsratiosuggestsconclusionsquite similarto those
the much narrower range 13.8 to 16.7. The relation of reachedby relatingthe priceto earningsprojectedseven
prices to earnings prospects is more adequately mea- years. Note, however,that a P/FE of 15 tendsto imply
sured, at least in terms of the valuations characteristic that earningsgrowthwill continue at the assumedrate
of the present market. Computations such as these are for 15 years. The approachcan be quite misleadingif
rarely if ever conclusive evidence that one stock is a the growth projectionis too high. It is often wise to
better value than another. Quantitative estimates or scale down a very high recentgrowthrate. Perhapsthe
measures of value are tools to be used in conjunction greatestadvantageof this approachis its convenience:
with many other considerations, such as investment one merely inspects a table to determinethe payout
quality and standing, the confidence in the projection, periodor P/FE associatedwith the currentmultipleand
evaluation of changes in a company's operations and the assumedrate of growth. (Copies of a more detailed
prospects, et cetera. In general, however, such consid- P/FE tablemay be obtainedfromthe authoron request.
erations can be given quantitative expression. If the Some reprintsof the August 1958 articleare available.)
results do not support conclusions reached in a more The price-futureearningsratio and the ratio of cur-
116 FINANCIAL ANALYSTS JOURNAL

This content downloaded from 91.229.248.187 on Tue, 17 Jun 2014 01:48:05 AM

All use subject to JSTOR Terms and Conditions
rent market to projected earnings in five or seven years
share one disadvantage: the dividend factor is ignored.
Payout, quality, confidence in future projections and
similar considerations can be taken into account through
modification of the growth rate, but this expedient is
somewhat awkward and imprecise. Nonetheless, when
used with discrimination these approaches have proved
to be effective as well as simple.
In the article on equity valuation in preparation a
somewhat more sophisticated approach using discount-
ing techniques will be developed. While not new or
original, such approaches are still unfamiliar to many
analysts. We will introduce some modifications which
may be of interest.
It is doubtless evident that mathematical approaches
can by no means resolve all the problems of equity
valuation. Their greatest value may lie in providing a
means of analyzing the implications of a given level of
stock prices and of identifying specific instances of over-
valuation and undervaluation more clearly. *

QUARTERLYDIVIDENDS SINCE 1935

NATIONAL
DISTI
LLERS
........... ~and
CHEMICAL
CORPORATION
DIVIDEND NOT/CE
The Board of Directors has declared a
quarterly dividend of 30? per share on
the outstanding Common Stock, pay-
able on June 1, 1964, to stockholders
of record on May 11, 1964. The transfer

ACE : KA O E How
It Worksin theUtilityField | April 23, 1964.
RAMSEY E. JOSLIN, Treasurer

AVERAGEPRICEOF RESIDENTIAL
ELECTRICITY
(DOWN)
UNITED STATES CALlFORNIA-PACIFIC UTILITIESCO.

4 __

1943 1963 1943 1963

It.J. iteynioIds
3.60% 2.37% 4.100 1.71% *
PER KWH PER KWH PER KWH PER KWH

AVERAGEUSE IN ELECTRIFIED
HOMES(UP)
UNITEDSTATES CALIFORNIA-PACIFICUTILITIES CO. ToUbacaao any
CIoAImpI
8
61
Makers of I
4 ~~~~~~~~~~~~~~Camel,
Winston,Salem&Cavalier
| _ 2 _ I I cigarettes
_ _ O _ _ |Prince Albert,GeorgeWashington
|
000
1943 1963 OF KWH 1943 1963 IkCarter Hall
1070 4465 1246 7345 i t
KWH KWH KWH KWH

QUARTERLY DIVIDEND
California-PacificUtilities specializes TOTAL NET A quarterly dividend of 45c
in providingsmall cities, villages and R
R EVENUES
ENUES INCOME
INCOME per share has been declared
rural areas with electric, gas, tele- on the Common Stock of the
phone, and other services. Catering 1943 $ 913,000 $ 133,000 Company, payable June 5,
to grass roots country, selling the 1964 to stockholders of record
big economy-size package at budget- 1953 7,111,000 595,000 at the close of business May
easy prices, has made the company 1963 14,515,000 1,275,000 15, 1964.
a real "growth situation ... To wit: ___*_I_I_
I WILLIAM R. LYBROOK,
Vice Presidentand Secretary
Winston-Salem N. C.
| @ / CALIFORNIA-PACIFIC
UTILITIES
COMPANY April 10 1964
550 CALIFORNIA STREET * SAN FRANCISCO, CALIFORNIA Sixty-four Consecutive Years of
Cash Dividend Payments

MAY-JUNE 1964 117

This content downloaded from 91.229.248.187 on Tue, 17 Jun 2014 01:48:05 AM

All use subject to JSTOR Terms and Conditions