Benjamin Graham is widely regarded to be the founder of modern value investing. His greatest student, Warren Buffett, attributes much of his success to Graham’s teachings.

Though Graham believed that much research is necessary, and that no stock screening methodology is perfect, he did give us some guidelines on how to perform initial screening techniques to limit the number of investments that should be researched further. The following is a list of the attributes he suggests investors look for first. The italics represent our changes to his methodology based on the current market:

1. Price-to-book (P/B) ratio of less than 1.2 (P/B < 1.5).

Intangible assets such as intellectual property, brand name recognition, and customer base, are not reflected in the price-to-book ratio, so we suggest a P/B of less than 1.5, rather than 1.2 that Graham discusses. He recognized this fact as well and commented that the P/B could be up to 2.5 if the company has significant intangible assets.

2. Earnings per share [EPS] should have grown by 33% in the past 10 years (Earnings growth of 3% or more in past 5 years).

Earnings thus should have grown around 3% per year. In this exercise, we go back 5 years, looking for 3%+ growth in earnings.

3. The price-to-earnings (ttm) ratio should be below 15.

Perhaps the most common valuation metric, the price-to-earnings ratio allows us to understand the earnings power of the company compared to its price. A high P/E ratio is common among “growth” stocks who are expecting phenomenal growth, but Graham believed that there is no way to be sure growth will continue at a pace that justifies the high price.

4. The current ratio should be above 1.5 (Quick Ratio > 1.5).

The current ratio represents the current assets divided the current liabilities. This ensures that if the company faces a crisis, they have 50% more assets than liabilities to work with. For this exercise, we are going to use the quick ratio instead, which is a more conservative number because it disregards any current assets that might be difficult to unload in a tight situation, such as inventory.

5. The company should pay out a dividend (>1%).

Dividends, in Graham’s opinion, are a very important indicator of a company’s financial health. Not only that, but they indicate a shareholder friendly management team, without which can spell disaster for shareholders. For this screener, we locate stocks that pay out more than 1% annually.

The Results

Now that we have mapped out what Graham thinks makes a good starting point for a list of investments, we will show you the results of running such a screener in today’s market.

The following companies meet or exceed Graham’s initial test and should be considered for review by the intelligent investor.

As always, don’t take these as recommendations, rather as a good place to start researching.

Disclosure: The author of this article does not own shares in any of the companies mentioned.

Freund Investing

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This article has 15 comments:

  •  
    Apr 09 05:34 AM
    Nice piece. I have to question your changes to Graham's methodology. Why push price-to-book up to 1.5 from 1.2? Most of these stocks would still show up with the 1.2 p/b ratio intact. I also question your change to length of earnings growth and use of EPS in general - with all the stock buybacks of late, EPS growth of 3% a year would indicate declining earnings in many cases. P/# below 15 - why? P/E is really a more industry specific gauge of value than a universal one. And the 1% dividend seems a bit weak in light of fallen stock prices, no?

    I think Graham's and Buffett's whole point was that you'll never get 35 stocks on a true value list. True values are few and far between and on occasion, non-existent.
  •  
    Apr 09 06:48 AM
    Time to pick up FMD tomorrow!
  •  
    Apr 09 08:22 AM
    good starting point for screening the stock universe. however, shortening the earnings history to 5 years from 10 is a very very serious flaw. you would think graham had chosen this period deliberately, not? of course he did. by looking at 5-year histories you run the very real risk of only capturing one phase of an economic cycle and this holds particularly true for the past 5 years where we have experienced an arttificially prolonged economic boom that led precisely to the current mess which is just beginning to unfold. i suggest you take 10 years not 5, it will help to avoid some sunshine-weather-only companies
  •  
    Apr 09 09:31 AM
    I always love these Graham pieces because every author somehow ends up with different results. Forbes just ran one from Validea and of course - no companies show up on both lists.
  •  
    Apr 09 10:36 AM
    Thanks for the comments everyone.

    Increasing the P/B and decreasing the years of earnings growth in the search gives more potentials. Personally, I like more potentials and will do my DD from the list. See, a company with a 1.5 price/book could very well be a fantastic investment, and I don't want to shut them out. Intangible assets are much higher than they were in Graham's days, and the price/book staying at 1.2 - as Graham suggested - cuts out some wonderful companies.

    As for the 5 year earnings, rather than 10 year earnings, I think you have a fantastic point FXTrader. I will take that into consideration.

    Flatman - this screener was derived 100% from Graham's book, "The Intelligent Investor," and I don't know how the results could be different. Unless, of course, Forbes was using different criteria.

    Thanks again everyone.
  •  
    Apr 09 10:38 AM
    Oh and User# - I would steer clear of FMD. It's too intertwined with the credit crunch and could very well be facing very serious problems.
  •  
    Apr 09 10:55 AM
    hi ryan, perhaps it will make sense to amend grahams criterias by adding a new one that takes into consideration the new environment in corporate finance that did not exist back then. it is stunning to see how many real or perceived "value investors" got creamed by buying into seemingly cheaply valued financial stocks only to discover that either the assets were worth much less, the liabilities way greater or the leverage so high and only short-term financed that the whole valuation assumed earlier proved inaccurate.
    so far i have no idea how to construct such a criterion. one might exclude banks and investment banks alltogether, of course but then one must also consider excluding some insurance companies that hold billions of yet-to-implode cdo exposure and then where does one stop? in any case it becopmes obvious that running a "graham" screen just provides a starting point that has to be followed by a closer examination of the numbers. for numbers don't lie but they might tell different stories depending how one looks at them
  •  
    Apr 09 11:30 AM
    FXTrader -

    You hit the nail on the head. That's exactly right. The screener simply provides a starting point. In my opinion, anything related to banks/housing/cars/ins... should be discarded immediately due to the issues surrounding credit.

    I would look for high cash, low debt companies with a moderate dividend to provide a safety net against losses. I would also be interested in any stocks that have significant global operations, as those are probably more resistant to a poor US economy than most.
  •  
    Apr 09 04:06 PM
    It would interesting to know the differences since the last time you ran, or month over month changes (I guess that's mostly due to chagnes in the P). Did it pick similar companies or vastly different? Or ones that were screened and chosen as Ben Graham stokcs in the past and how well they did since. Or do you think short term vol skews this too much?
  •  
    Apr 09 04:23 PM
    Many of the stocks are similar. Ben Graham advocated long term holding, so I doubt any meaningful information can be gleaned by comparing the prices. But I will keep doing this each month and it will be possible to track it through some backtracking.
  •  
    Apr 09 06:35 PM
    I believe FMD no longer pays a dividend. With TERI's bankruptcy and the securitization market frozen, FMD has no operable business plan and no guarantor for the loans. I would stay away from FMD.
  •  
    Apr 09 07:19 PM
    I would do the same, Metal27. FMD is not a good play right now, unless, of course, you like gambling.
  •  
    Apr 10 05:14 PM
    Graham, Dodd & Cottle + Roger F.Murray would add a quality of management component to these metrics, such as the ability to accurately predict and control EPS. I don't think there was much management forecasting back in their days.

    A company with good management systems and controls has great value to the investor. The banks failed this BIG TIME. I think their focus on "retail" banking was at the expense of the required focus on due dilligence in their investments. I think many bank managers do not understand the investment side of their business and this had led to a massive corruption of the capital markets.
  •  
    Apr 11 02:15 PM
    User 164820 - I agree 100% and that's why this isn't a list of buys, rather a list of companies to research further. Perhaps I'll try to add EPS accuracy to the screener.

    Thanks for the feedback!

    Ryan
  •  
    Apr 12 08:29 AM
    Espey is a good one. Nice dividend too. See my piece on ESP in Seeeking Alpha - Ed Roche, Freedom Mountain Investments
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