Benjamin Graham Pt. 2
- Adam Edwards
- Nov 9, 2024
- 4 min read
Benjamin Graham developed a methodical approach to evaluating investments by focusing on specific financial ratios and metrics to uncover undervalued stocks with a strong margin of safety. Here’s a breakdown of the key ratios and metrics he valued, along with what he typically looked for in the financial statements:
The key ratios and metrics he valued
1. Price-to-Earnings (P/E) Ratio
Metric: The P/E ratio compares a company’s share price to its earnings per share (EPS).
Graham's View: Graham preferred stocks with a low P/E ratio, generally below 15. A low P/E ratio suggests that the stock is undervalued relative to its earnings, making it a potential candidate for value investing.
2. Price-to-Book (P/B) Ratio
Metric: The P/B ratio compares the market value of a company’s shares to its book value (the net assets of the company).
Graham's View: Graham looked for stocks with a P/B ratio below 1.5. He wanted to ensure he was paying less than what the company’s tangible assets were worth. If the market price was below book value, the company might be undervalued, offering a margin of safety.
3. Current Ratio
Metric: The current ratio measures a company's ability to cover its short-term liabilities with its short-term assets. It’s calculated as Current Assets / Current Liabilities.
Graham's View: Graham preferred a current ratio of at least 2:1, indicating that the company has twice as many liquid assets as liabilities. A high current ratio means a stronger liquidity position, reducing the risk of insolvency.
4. Debt-to-Equity (D/E) Ratio
Metric: This ratio measures the proportion of debt to equity in a company’s capital structure. It’s calculated as Total Debt / Total Equity.
Graham's View: He preferred companies with a low D/E ratio, typically below 1.0, indicating a conservative use of debt. A lower D/E ratio suggests that the company is less reliant on debt financing, making it more resilient in downturns.
5. Earnings Stability
Metric: Consistency in earnings, often measured by examining the net income over the past 5-10 years.
Graham's View: Graham valued companies with stable earnings over time. He often required that a company show positive earnings for at least the past 10 years. Stability indicates a reliable business model that can weather economic cycles.
6. Dividend Record
Metric: The consistency and growth of dividends paid out by the company.
Graham's View: He preferred companies with a stable history of dividend payments, ideally for 20 years or more. Dividend payments signal financial health and a commitment to returning value to shareholders, which can enhance returns.
7. Earnings Growth
Metric: Graham sought modest but steady growth in earnings per share (EPS) over time.
Graham's View: Although he didn’t focus on rapid growth, he looked for companies with at least a 10-15% increase in EPS over the past decade. This indicates healthy, consistent growth rather than speculative high growth.
8. Net Working Capital (NWC)
Metric: NWC is calculated as Current Assets - Current Liabilities. It measures the short-term financial health of the company.
Graham's View: Graham aimed to invest in companies where the NWC exceeded the company’s long-term debt, indicating strong liquidity and an ability to cover long-term obligations.
9. Earnings Yield
Metric: This is calculated as Earnings per Share / Price per Share, or the inverse of the P/E ratio.
Graham's View: He looked for an earnings yield that was at least as high as the interest yield on bonds. A higher earnings yield indicates better value and a lower risk relative to returns on fixed-income securities.
What Graham Looked for in Financial Statements
Balance Sheet
Assets: He focused on the book value of assets, especially cash, receivables, and inventory, and valued tangible over intangible assets.
Liabilities: He scrutinised liabilities to assess debt levels, favouring companies with low debt-to-equity ratios. He avoided companies with excessive leverage.
Equity: Graham valued strong equity, which he felt acted as a buffer in adverse times. He wanted shareholders’ equity (or book value) to be high relative to market capitalisation.
Income Statement
Revenue Stability: Graham favoured steady or slowly growing revenue, avoiding companies with highly volatile earnings.
Profitability: He focused on net income and preferred companies with stable profits. Graham avoided companies with irregular or negative earnings, as they lack consistency.
Cost Management: He examined gross and operating margins to ensure costs were under control, which supports a company's ability to withstand downturns.
Cash Flow Statement
While Graham’s era did not emphasise cash flow as much, modern interpretations of his philosophy incorporate it. Today, investors inspired by Graham look at operating cash flow for insights into a company's real cash generation and its ability to cover dividends, debt, and capital expenditures.
Summary of Graham’s Key Financial Metrics
Graham’s focus was on conservative, fundamentally sound financial indicators that highlight stability, intrinsic value, and financial resilience. His approach often entails rigorous screening using these ratios to ensure a solid margin of safety. This detailed analysis reduces risk and helps investors make rational, informed choices independent of market trends or emotions.