Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.
Having determined the true earnings power of a company (as discussed in the preceding chapters), the investor is now ready to determine an appropriate multiple by which to multiply the earnings to approximate its intrinsic value.
In the markets, the various multiples given to stocks have two main components: the prevailing market psychology and the prospects of the enterprise. The authors note that Wall Street places undue importance on earnings trends in determining the prospects of the enterprise.
It's important to note that an exact appraisal of the proper multiple is impossible. However, by using factors Wall Street does not place enough weight on (e.g. capital structure, unusual balance sheet items), the security analyst can determine a basis for conservative investment.
The authors set a benchmark 10 should be the starting point in determining the multiple of most companies. Furthermore, the investor should rarely pay more than a P/E of 16, since this would represent an earnings power of less than 6% of investment, and therefore it amounts to speculation. The investor may place a higher P/E multiple on companies with current earnings higher than their earnings power, or on those with bright prospects, however, consistent purchases at P/E's above 16 will result in losses.
A company's source of income is also an important parameter of income. For example, if it is receiving interest payments of $1 per share off high grade bonds worth $20/share, it makes no sense to blindly apply a 10x multiplier to the $1 in income. In such a case, the earnings power of the business operations may warrant a 10x earnings multiplier, but the $20/sh in cash should be added to the final value.
Finally, a company's capital structure (debt vs equity) plays an important role in determining an appropriate multiple. Too conservatively capitalized companies don't allow equity owners to safely benefit from rises in earnings (due to leverage benefits) while companies loaded with debt are too risky. A company whose senior debt is just of investment grade (as discussed in Chapter 8 and subsequent chapters) would tend to maximize it's P/E multiple.