Let's wade through a little arithmetic about book and market value. When stocks consistently sell at book value, it's all very simple. If a stock has a book value of $100 and also an average market value of $100, 12% earnings by business will produce a 12% return for the investor (less those frictional costs, which we'll ignore for the moment). If the payout ratio is 50%, our investor will get $6 via dividends and a further $6 from the increase in the book value of the business, which will, of course, be reflected in the market value of his holdings.
If the stock sold at 150% of book value, the picture would change. The investor would receive the same $6 cash dividend, but it would now represent only a 4% return on his $150 cost. The book value of the business would still increase by 6% (to $106) and the market value of the investor's holdings, valued consistently at 150% of book value, would similarly increase by 6% (to $159). But the investor's total return, i.e., from appreciation plus dividends, would be only 10% versus the underlying 12% earned by the business.
When the investor buys in below book value, the process is reversed. For example, if the stock sells at 80% of book value, the same earnings and payout assumptions would yield 7.5% from dividends ($6 on an $80 price) and 6% from appreciation -- a total return of 13.5%. In other words, you do better by buying at a discount rather than a premium, just as common sense would suggest.
During the postwar years, the market value of the Dow Jones industrials has been as low as 84% of book value (in 1974) and as high as 232% (in 1965); most of the time the ratio has been well over 100%. (Early this spring, it was around 110%.) Let's assume that in the future the ratio will be something close to 100%, meaning that investors in stocks could earn the full 12%. At least, they could earn that figure before taxes and before inflation.
The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5% passbook account whether she pays 100% income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5% inflation. Either way, she is "taxed" in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120% income tax, but doesn't seem to notice that 6% inflation is the economic equivalent.
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