Benjamin Graham – otherwise known by his moniker, the ‘father of value investing,’ is renowned for designing a famous formula for the purpose of identifying under-priced stocks. When it comes to value investing, one of the key skills of any investor worth their salt is knowing how to adequately value a stock. Becoming familiar with how to pinpoint undervalued stocks and the Graham Formula, in that case, is a common starting point for any would-be investor.
Graham, who was the foremost voice in value investing for a period of the early 20th century, devised a method which was comprised of seven steps. This method was published in his famous book, “The Intelligent Investor”. Graham’s criteria involved strategizing to find and value stocks which would attain a level of considerable price appreciation.
By understanding how news and events can affect a stock’s value, regardless of any fundamental effect of future pricing, one can begin to understand this strategy. Below are Graham’s Criteria for identifying under-priced value stocks:
- The first step of seven in Graham’s guide for identifying undervalued stocks is to look for those with a quality rating of average or better. Graham advised utilizing Standard & Poor’s (S&P’s) rating system, choosing stocks which had an S&P Earnings & Dividend Rating which was at least B, if not better.
- Any investment made should be done against companies with Total Debt to Current Asset ratios below 1.10. It is crucial to only invest in companies with low debt loads in times of economic weakness, given the restrictions on lending. In order to find the Total Debt to Current Asset ratios, you can look up S&P’s or Value Line.
- Graham advised to always validate the current assets divided by current liabilities of a company (the Current Ratio). Companies with a ratio exceeding 1.50 are considered as worthy of investing, in this regard.
- Research a company’s positive earnings per share growth over the past five year period in order to gauge its performance. Companies that have not demonstrated an increase in growth over five years, or have yielded unpredictable performance levels, are risky.
- Ideally select stocks which carry a price to earnings per share (P/E) ratio of 9.0 or below, as the exercise is based on snapping up companies which are under-priced. Companies with low P/Es are generally not considered as high-growth.
- Price to Book Value (P/BV) ratios will ideally be less than 1.20, although there still is some uncertainty regarding this particular criterion. As a value investor looking to buy stocks which are not selling under their book value, you will be concerned with the underlying value of the company you are interested in.
- By dividing the current stock price by the book value per share, you will calculate the P/BV ratio, which will help you better understand its situation.
- It is advisable to choose companies which pay steady dividends, according to Graham. As the stocks which are undervalued today may eventually attract more and more investors who eye opportunity, the chances are that this will be gradual. Once you are receiving dividends while you are waiting for this transition, the wait will be a lot easier and more profitable.
Points to consider
While the criteria above is a fine example of key points to consider when value investing, there are other details which make things a little more complicated. If a company is undervalued, what are the underlying conditions which have contributed to its price, and should that be cause for concern?
Will any particular issue be resolved, or is it likely to lead to long term problems which could compromise your investment?
About the writer: Jeremy Biberdorf is the owner & founder of the popular investing blog modestmoney.com. Check out his site for latest investing news and tips! Follow ModestMoney on Twitter and connect with Jeremy Biberdorf on Facebook.