Who is Benjamin Graham?
Benjamin Graham is famously known as the Father of Value Investing. He was born in 1894 in London, United Kingdom. He was an economist, professor, and investor.
Graham was fluent in at least seven languages, including ancient Greek and Latin. He attended Columbia University on a scholarship. He later received a job offer on Wall Street with Newburger, Henderson, and Loeb. Graham was earning US $ 5,00,000 annually by the age of 25.
Warren Buffett considers Benjamin Graham as his guru.
Benjamin Graham learned investing the hard way. During the Bank Panic of 1907, Graham and his family lost their entire savings. The same happened during the stock market crash of 1929.
But these events did teach him some valuable investing lessons.
His learnings after the crash inspired him to write a research book with David Dodd. It is famously called Security Analysis. We will discuss this book in brief further in this article. Let’s understand his investment strategy in detail first.
Benjamin Graham and Value Investing
Graham built a heap of wealth by picking the best-valued companies. He strictly followed and advocated value investing. He preferred investing in stocks at a temporary low price compared to their intrinsic value. As one can imagine, finding such companies is not a cakewalk.
Before we understand the criteria Graham uses to value stocks, let’s briefly understand what is intrinsic value.
Benjamin Graham’s Formula to Intrinsic Value
Value Investing is buying stocks below their intrinsic value. Intrinsic value is calculated based on a company’s assets, earnings, etc.
Intrinsic value can be calculated using various financial models. But not all retail investors know how to use a financial model. Given its complexity, it is difficult to learn in if you hate maths or complex calculations.
So, what to do? How would a retail investor decide if the stock is fairly priced or not?
Benjamin Graham’s formula for finding stocks valuations comes to the rescue. The formula is mentioned in his books Security Analysis and The Intelligent Investor.
Benjamin Graham’s Intrinsic Value formula says:
Intrinsic value = EPS × [(8.5 + 2G)]
- 8.5 is the price to earnings (PE) base for a no-growth company.
- ‘G‘ is the expected annual growth rate. It is the estimated growth rate over seven to ten years.
In 1974, in the revised edition of The Intelligent Investor, Graham revised the formula to –
Intrinsic value = EPS × (8.5 + 2g) × 4.4]/Y
- 4.4 is the 1963’s prevailing rate on New York Stock Exchange’s high-grade corporate bonds.
- Y is the current yield on AAA-rated corporate bonds.
This is as per International Markets. To fit Graham’s formula in Indian markets, three minor edits are made in the formula.
Intrinsic value (for Indian stocks) = EPS × (7 + g) × 6.5]/Y
Let’s understand these formula edits.
- We replace 4.4 with 6.5.
4.4 is the interest rate on high-grade bonds. In other words, is the substitute of the risk-free return.
Instead, we will use five-year fixed deposit rate of 6.5%.
- Use PE of 7 instead of 8.5
Depending on how conservative you are, PE between 7 and 8.5 is fine.
We do this because even if a company has no growth expectations, they are able to manage cash flows and distribute dividends. So, its P/E would be higher than 8.5.
- The multiplier ‘2’ is very aggressive.
Graham hardly experienced a growth rate of 15% to 20% from companies. There were not many companies in his time with such high growth rates. Hench a growth multiplier of 2 for him is understandable.
However, a growth rate of over 15% is very common today. ‘2’ as a growth multiplier would make the value calculation very aggressive.
Hence, instead of ‘2’, we reduce the multiplier to 1 or 1.5.
This is how we derive to –
Intrinsic value (for Indian scrips) = EPS × (7 + g) × 6.5]/Y
But remember, this simple calculation is not a substitute to the valuation models. The formula will help you find a rough estimate close to the valuation but not the true value.
- If intrinsic value > current market price = Undervalued Stock
- If intrinsic value < current market price = Overvalued stock
Investors must buy and hold undervalued stocks. This way, you pay less for a stock than its ideal stock price.
Investors must avoid investing in overvalued companies.
How to analyse a company? – The Graham Way
Graham uses various criteria to value stocks. Here are the important factors Graham evaluates before investing in a company.
- Stability, Profitability, and Growth
Graham focuses on companies that perform consistently. . It gives a sense of stability and smooth operations. For this, he evaluates company’s past 10 years EPS trend.
Earnings per share of a company is the net profit after taxes. It measures the profit available for the shareholders for each share held.
Profitability is another important factor to consider while analysing companies. It measures the ability of a company to generate profit compared to its expenses. Without generating profits, a company cannot sustain itself in the long term.
Lastly, Graham taps into peer-topper comparison before investing in a company. He compares the growth of one potential company with the growth of its equivalents. If the growth of the peer company is higher and better, then investing in that company is preferable.
- Financial position, debt history, and leverage
A company’s financial position is another crucial factor in stock analysis. You wouldn’t want to invest in a company that is not financially healthy. Right?
To examine a company’s financial heath, you must analyse a company’s fundamentals.
Graham uses the debt to asset ratio to compare debts with the assets of the company. The company must own more assets than its debt in order to be qualified as notable for investing.
He reviews the price history of the company before investing. He prefers companies whose share price increased steadily over the years.
Financial Leverage is the use of debt to acquire more assets. It is the use of borrowed funds (debt) to finance the purchase of new assets.
Companies expect that the capital gain from the new asset will exceed the cost of borrowing. However, this comes with a lot of risks and uncertainty.
Low financial leverage is an ideal pick. For example –
Reliance Industries uses Rs. 5 crores of its own cash and a loan of Rs. 30 crores to buy a new factory.
The new factory generates an annual profit of Rs. 7 crores.
Reliance Industries is using financial leverage to generate a profit of Rs. 7 crores on a cash investment of Rs. 5 crores. This is a 140% return on its investment.
A couple of years later, they incur a loss of Rs. 15 crores. This is three times their original investment. Now, they have a loss to work up to and a loan amount to repay.
Graham suggests selecting a company with debt less than 110% of the net current assets. In other words, it must be less than less than 1.10. Particularly for industrial companies.
- Current ratio
This is an important indicator which investors need to reflect on. The current ratio is a liquidity ratio. It is also known as the working capital ratio. It signifies a company’s ability to pay short-term liabilities.
- Current Ratio formula = Current Asset / Current Liabilities
Ideally, the current asset ratio must at least be one time of current liabilities. Graham preferred companies with ratios over 1.50.
Current ratio of more than one means the company is able to manage its short-term obligations. Such companies are more preferable for investment.
Current ratio of less than one means that the company can face cash crunch while repaying its creditors. This happens if the current liabilities are more than the current assets. The chances of the company defaulting on payments is also high.
- Price to earnings ratio (PE) and Earning Per Share (EPS)
The PE ratio and percentage change in the EPS are important factors in value investing. PE ratio helps us understand if we are buying the stock at its fair value. Earnings Per Share gives us a perspective about companies’ future growth. It also helps us understand their ability to pay dividends.
Benjamin Graham advises one must select a company with a low to moderate PE ratio. Whereas, the company’s EPS must be positive. A negative EPS suggests that the company is making losses for its shareholders.
- Price to book value (PB) Ratio
PB Ratio compares a company’s current market value to its book value. Book value is the total asset of the company minus its outstanding liabilities.
Investors must invest in stocks that are trading below the company’s book value.
A higher price to book value ratio depicts that the stock is expensive. Investors should select companies with a price to book value ratio of less than 1.20.
Also Read: How to use PB ratio in stock analysis
- Preservation of capital
Graham recommends preserving capital first and then let the investments grow.
This is a conservative investment strategy. It suggests that investors should invest in the safest short-term fixed-income securities. For example, treasury bills and certificates of deposits.
He recommended dividing the portfolio between stocks and bonds. This preserves capital during extreme market crashes.
Graham recommends having 25% to 75% of investment in bonds. The same is to be modified on the basis of broader market valuations. If the equity markets are expensive then move 75% portfolio to bonds. If they are cheap then keep only 25% portfolio in bonds.
- Margin of safety and diversification
Benjamin Graham recommends having a bigger margin of safety. He suggests buying stocks when they are available cheap.
This approach helps investors get a good night’s sleep.
The margin of safety is the margin required to ensure safety for unpredicted risk. To reduce this risk, the art of diversification comes to the rescue.
The margin of safety blends in with diversification. Graham suggested holding at least 30 stocks in the portfolio to ensure diversification.
Graham once said on diversification that –
‘Even with a margin in the investor’s favour, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss – not that loss is impossible.
But as the number of such commitments is increased, the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses. That is the simple basis of the insurance-underwriting business.’
Must Read Books by Benjamin Graham:
Graham’s books deal with both technical as well as emotional aspects of investing.
The first book Graham wrote revolutionised investing for everyone. It was Security Analysis. Another book which is often quoted by everyone is considered to be the bible of Investment. It is The Intelligent Investor.
Let’s understand in brief why these two books stand out from the rest.
- Security Analysis by Benjamin Graham and David Dodd
Security Analysis was originally published in 1934. It was written during the start of the Great Depression. Graham was a lecturer at Columbia Business School at that point.
Graham and Dodd saw and survived the Great Depression as well as the instabilities of World War II. They then managed to create wealth by outlining a strategy in the latter half of the century.
Security Analysis lays down the fundamentals of value investing. The concepts of margin of safety and intrinsic value were introduced in this book.
Warren Buffett has read this book at least four times! He says ‘Security Analysis provided a road map for investing that I have now been following for 57 years.’
The book sheds light on how to analyse all kinds of investments. It does not specifically focus only on common stocks. A great proportion of the book is devoted to the analysis of bonds and preferred issues.
The techniques mentioned in the book remains applicable even today…seven decades after publishing!
Security Analysis will always remain a “must have” book in every investor’s library.
- Intelligent Investor by Benjamin Graham
‘But investing isn’t about beating others at their game. It’s about controlling yourself at your own game.’
Intelligent Investor is one of the best and most practical books about investments. Benjamin Graham first published the book in 1949.
It received global acknowledgment as the greatest investment advisor of the 20th century.
Graham says that two things remain common with value investors. Regardless of which technique one follow –
- They are disciplined and consistent, refusing to change their approach even when it is unfashionable.
- They think a great deal about what they do and how to do it, but they pay very little attention to what the market is doing.
Buffett has praised The Intelligent Investor on several occasions. He mentioned it in his 2013 letter saying –
‘I learned most of the thoughts in this investment discussion from Ben’s book The Intelligent Investor, which I bought in 1949. My financial life changed with that purchase. Of all the investments I ever made, buying Ben’s book was the best.’
Buffett considers this book to be his bible for investing.
It lays the foundation for laymen by giving a thoughtful yet simple approach to investing.
Benjamin Graham died in the year 1976. But, his work lives on and is still extensively used in the twenty-first century. The father of value investing left behind a pool of wisdom for investors to create wealth in his books.
He was a lifelong advocate of value investing.. He created a style of investment with a proven track record of outperformance.
The key learning in his investment philosophy is to not follow him blindly. Investors should carry out extensive research before buying a stock.Here is a list of seven books for beginners to learn about investment.