Value Investing – part 1

Stock Evaluation – Benjamin Graham method

In my ongoing quest to look at finances and improve my financial performance, I’ve done a lot of reading on value investing. The general concept of value investing is that you can, with some accuracy, determine the intrinsic value of a stock.  However, the stock market is often based on emotions, and a stock can be selling for less than its intrinsic value (due to bad news and overreaction, general lack of knowledge of a certain company’s performance, or the stock not being in a “sexy” industry.

I worked for a company in 2000 that was in automotive (i.e. not a “sexy” dotcom in 1999 -2000). Very well run, great numbers, but only trading at $1.68 a share. Once the dotcoms blew up, people starting looking for other companies to buy and found ours. Over the next seven years, it went over $140/share (taking into account splits). While we did great work at this company, even I don’t think it was worth a 833% rise in value.

The key for a value investor is to find these “diamonds in the rough,” purchase them, and then have the patience to wait till they jump up. If you can judge the intrinsic value, it may take the market a year, or 5 years, but eventually you will be rewarded.

Note that this is the exact opposite of the “efficient market” theory that rules Wall Street at this time – the belief that information is known to all, and therefore the market is correctly priced, each day. These investors tend to emphasize hot growth stocks. However, if everyone had total knowledge, why are there always sellers and buyers for a share of stock, with both of them thinking they made a good deal?

One of the earliest proponents of the value theory was Benjamin Graham, and most of the big value investors are disciples of his teachings (Warren Buffet and many others actually took classes from Graham and worked for him).

In looking through books authored by Graham, liked The Intelligent Investor, or other value investors, they ended up with a process to evaluate and pick value stocks:

  1. Learn to understand a company’s basic financial documents (balance sheet, earnings statement, cash flow)
  2. Use simple metrics (I will show Graham’s ten values) to weed out the majority of non-value stocks
  3. Once you have identified a list of candidates, use some additional rules to weed out those value-type stocks that don’t match your goals, or who are questionable
  4. Invest and show patience while you wait for the market to agree with your valuation.

I won’t go into details here on how to reach a company’s documents. There is a wide variety of information on-line, but here are some, in case you need them:

  1. Reading a balance sheet 
  2. Reading an earning’s statement
  3. Reading a cash flow statement

For step 2, Benjamin Graham (and other value investors) used a series of ratios to weed out the stocks that did not meet their value objectives

No Criteria Measures
1 Earnings to price (the inverse of P/E) is double the high-grade corporate bond yield. If the high-grade bon yields 7%, then earnings to price should be 14% Risk
2 P/E ratio that is 0.4 times the highest average P/E achieve in the last 5 years Risk
3 Dividend is 2/3 the high-grade bond yield Risk
4 Stock price of 2/3 the tangible book value per share Risk
5 Stock price of 2/3 the net current asset value Risk
6 Total debt is lower than tangible book value Financial Strength
7 Current ratio (current assets / current liabilities) is greater than 2 Financial Strength
8 Total debt is no more than liquidation value Financial Strength
9 Earnings have doubled in most recent ten years Earnings Stability
10 Earnings have  declined no more than 5% in 2 years of the past 10 years Earnings Stability
If stocks meet seven out of the ten criteria, it is probably a good value, according to Graham. If you are income oriented, recommended to pay special attention to items 1 – 7

Graham’s criteria from Value Investing for Dummies

In my next post, I’ll explain how I used these criteria to identify a group of stocks, and then did further research in order to pick one for my “fun money” account. You’ll get to see how I did there.

 

Mr.39 Months

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