Intelligent Investor Example from Chapter 1

Question

As per Intelligent Investor Chapter 1 example

In 1965 the investor could obtain about 4½% on high-grade taxable bonds and 3¼% on good tax-free bonds. The dividend return on leading common stocks (with the DJIA at 892) was only about 3.2%. This fact, and others, suggested caution. We implied that “at normal levels of the market” the investor should be able to obtain an initial dividend return of between 3½% and 4½% on his stock purchases, to which should be added a steady increase in underlying value (and in the “normal market price”) of a representative stock list of about the same amount, giving a return from dividends and appreciation combined of about 7½% per year.

• Why at normal levels dividend expectation should be 3.5 - 4.5?
• How this dividend and appreciation adds to 7.5%?

I am trying to understand the math behind these numbers.

Answer 1

The second part of your question is how the total return of the stock investment equaled 7.5%

Annual % return = % change in stock price + yearly dividend 

Graham said the yearly dividend is between 3.5% and 4.5% of the stock price. Next, he said to expect (at that time)

a steady increase in underlying value (and in the “normal market price”) of a representative stock list of about the same amount

So annual return would be stock appreciation of 3.5% to 4.5% plus dividend yield of 3.5% to 4.5%. Let's just take the average of each, which is 4% increase in stock price and 4% for dividends. That adds up to 8% total. Graham was cautious and rounded down slightly to 7.5% possibly because the investor might not be holding an ideally representative list of stocks.

Now for the first part of your question: Graham said that stock dividends should be 3.5% to 4.5% under normal market conditions but in 1965, dividends were only 3.2%. This was why he was suggesting that a more cautious mix between stocks and bonds might be prudent in the rest of the linked excerpt from Intelligent Investor here. He was specifically referring to dividend expectations in US markets of that era, from 1949 through the early 1970s, which are not the same as now.

(Read the rest of the excerpt in the linked question, in which Graham compares what he said five years earlier with what he is saying in this text. That's how you can tell that this screenshot is from the Fourth Revised Edition of Intelligent Investor ISBN 0-06-015547-7 written in 1970-1971 and that Graham was referring back to the Third Edition of Intelligent Investor, as it was written and published in 1965.)