Benjamin Graham (3)

WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

Benjamin Graham wanted to find several characteristics in a company before he would consider purchasing its stock.  If he was able to purchase a company's stock with a price below what those metrics showed the company to be worth, he had the "margin of safety" he was always looking for.  If the stock price is already low, then the chance of a further significant decline is diminished.  To put it bluntly, Graham wanted to buy stocks on the cheap.

He looked for companies undervalued by the market.  A quick measure of this is the price/earnings (p/e) ratio, which is the market price of the stock divided by the earnings per share (usually for the prior four quarters).  This ratio shows what investors in the market are willing to pay for each $1 of company earnings.  The lower the ratio, the cheaper the stock.  Another way to look at the p/e ratio is to think of the ratio in years.  If the company earned $2 per share in the last year and the price is $30 per share today (p/e of 15), it will take 15 years for the company to earn the price of the share if earnings remain the same.  Remember, this is earnings, not dividends.

Graham was able to find such stocks over many years in every kind of market.  Graham also looked at the converse of the p/e ratio - the earnings/price ratio.  He recommended that the investor look for a company with an earnings/price ratio equal to or greater than the prevailing interest rate for high grade (AA or better) corporate bonds. This comparison of the earnings/price ratio to the interest rate of high quality corporate bonds actually served to establish the p/e ratio he was looking for in a company.  As an example, let's assume that the prevailing interest rate for bonds rated AA or above is 6% (6 divided by 100).  He would then look for a company with a p/e ratio which was the converse of  6%;  a p/e ratio of 17 (100 divided by 6).  In a 6% bond market, Mr. Graham advised the investor to limit his or her investments to companies with a p/e ratio of 17 or less.  This is simple math, but it serves to protect the investor from making expensive purchase mistakes.  As the earnings/price ratio changes in the market, so does the p/e ratio.  So too, the companies meeting that test will change.

 In addition to investing based on the p/e ratio,  Mr. Graham recommended limiting your investing to companies with the following additional financial benchmarks:  (i) current assets which exceeded current liabilities by 150%; (ii) debt of not more than 110% of current assets; (iii) earnings which were growing for each of the last five years (no losses in any year); (iv) a record of increasing dividends over a good number of years; and (v) a price which was less than 120% of the net tangible assets.

Being able to calculate these measures requires a certain  level of familiarity with accounting terms.  Not to worry.  We will talk briefly, I assure you, about accounting terms in the next blog.

Comments are always welcome.