In a must-read book, “Templeton’s Way with Money”, the authors, Jonathan Davis and Alasdair Nairn, reproduce a memo written by Sir John Templeton to his clients in 1954 on calculating the “normal” level of stock prices.
“The economic theory developed by Templeton, Dobbrow & Vance, Inc. for calculating the normal level of stock prices is simple. There are only three elements:
1. Stock prices would be normal if they bore the same relationship to current earnings as has been customary in the latest 20 years.
2. Stock prices would be normal if they bore the same relationship to the current cost of replacing the assets of the corporations as has been customary in the latest 20 years.
3. When, because of changes in tax laws or changes in the money supply, high-grade preferred stocks sell lower in relation to dividends than has been customary in the last 20 years, then it should be normal for common stocks to sell lower in relation to earnings; and vice versa.
Although the theory is simple, the actual calculation involves many thousands of figures. We take care to define accurately each word used in the three principles above; and then the arithmetic is worked out on the basis of a large sample of representative stocks.
The estimate of normal based on the three principles above is valid only when applied to a diversified list of industrial common stocks. Different principles are needed if we attempt to appraise the normal for any particular stock. In order that our calculations may be always up-to-date, normal for stock prices is recalculated each month.
In the latest 20 years normal has shown a strong upward tendency, partly because of the change in the purchasing power of the dollar, but more importantly because corporations have retained (after payment of dividends) a large part of their earnings each year.
Normal for stock prices based on the principles expressed above has been computed consistently at a higher figure than the figure arrived at by any other agency attempting to calculate normal. This has meant that the clients of Templeton, Dobbrow & Vance, Inc. have been more heavily invested in common stocks and this has been a profitable situation so far.”