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I am reading the revised edition of Ben Graham's THE INTELLIGENT INVESTOR (First Collins Business Essentials Edition, 2006) with commentaries by Jason Zweig.

In chapter 7, "Portfolio Policy for the Enterprising Investor: the Positive Side", under the section "Purchase of Bargain Issues" (p. 169), Graham gives Northern Pacific Railway as an example: It declined from 36 to 13.5 in 1946-47 and the true EPS in 1947 was $10.

Then he says that the price of the stock was held down in great part by its $1 dividend. What does this mean?

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Without reading the source, from your description it seems that the author believes that this particular company was undervalued in the marketplace. It seems that investors were blinded by a small dividend, without considering the actual value of the company they were owners of. Remember that a shareholder has the right to their proportion of the company's net value, and that amount will be distributed both (a) in the form of dividends and (b) on liquidation of the company.

Theoretically, EPS is an indication of how much value an investor's single share has increased by in the year [of course this is not accurate, because accounting income does not directly correlate with company value increase, but it is a good indicator]. This means in this example that each share had a return of $10, of which the investors only received $1. The remainder sat in the company for further investment.

Considering that liquidation may never happen, particularly within the time-frame that a particular investor wants to hold a share, some investors may undervalue share return that does not come in the form of a dividend. This may or may not be legitimate, because if the company reinvests its profits in poorer performing projects, the investors would have been better off getting the dividend immediately. However some value does need to be given to the non-dividend ownership of the company.

It seems the author believes that investors failing to consider value of the non-dividend part of the corporation's shares in question led to an undervaluation of the company's shares in the market.

  • Yes, the author states A third cause for an unduly low price for a common stock may be the market's failure to recognize its true earnings picture and then gives Northern Pacific as an example. Then later he states It was neglected also because much of its earnings power was concealed by accounting methods peculiar to railroads – arun Aug 8 '16 at 15:53
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The company was paying "only" $1 a share in dividends, compared to $10 a share in earnings. That is a so-called payout ratio of 10%, which is low. A more normal payout ratio would be 40%, something like $4 a share. If a $13 stock had a $4 dividend, the dividend yield would be about 30%, which would be "too high," meaning that the price would go up to drive down the resulting yield. Even $1 a share on a $13 stock is a high dividend of about 7%, allowing for appreciation to say, the $20-$25 range.

Graham was a great believer in the theory that management should pay out "most" of its earnings in dividends. He believed that by holding dividends so far below earnings, the company was either being "stingy," or signalling that the $10 a share of earnings was unsustainable. Either of these would be bad for the stock. For instance, if $1 a share in dividends actually represented a 40% payout ratio, it would signal management's belief that they could normally earn only $2.50 a year instead of $10.

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Two of the main ways that investors benefit financially from a stock are dividends and increases in the price of the stock. In the example as described, the benefits came primarily from dividends, leaving less benefits to be realized in terms of an increase in the value of the company.

Another way to put that is that the company paid its profits to shareholders in the form of a dividend, instead of accumulating that as an increase in the value of the company. The company could have chosen to take those profits and reinvest them in growing the business, which would lead to lower dividends but (hopefully) an increase in the valuation of the stock, but they chose to pay dividends instead. This still rewards the investors, but share prices stay low.

  • I agree with your first paragraph, but am not sure about your conclusion. It seems that with EPS of $10, a $1 dividend is actually quite low, and therefore it seems the problem noted by the author of the OP's book is that the investors were not properly valuing the company due to its low dividend paying policy. – Grade 'Eh' Bacon Aug 8 '16 at 15:19

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