The core of value investing is to obtain an investment for less than its worth. Professional investors will typically focus on the price to earnings (P/E) ratio which compares the current share price with its per share earnings. Although this is a good gauge, more than one ratio should be considered when assessing an investment. Students of value investing should also be familiar with price to book (P/B) ratio. This ratio (P/B) compares the current share price to the current shareholder equity.
In the book The Intelligent Investor, Benjamin Graham highlights a key concept which combined the two ratios [P/E and P/B] as a gauge on the valuation of a company. These combined ratios are known as the Graham ratio. The computation is elementary, simply multiply the P/E ratio with the P/B ratio. If the product is less than 22.5, the company may be of good value. This thesis is highlighted in Chapter 14 - Stock Selection for the Defensive Investor of The Intelligent Investor. We find this concept to be so compelling that we've decided to back test this ratio against our watch lists from 2012.
We started with our U.S. Dividend Watch Lists from May 11, 2012 through August 24, 2012 and compared the share price after two years. Because many companies appeared on our list multiple times, we selected only the instances with the least amount of return. We then split the list into two sections, one with companies that meet the Graham ratio and others that fail. We believe the results are distinct and worth reviewing.
Each list contains 31 companies. The list of companies meeting the Graham ratio criteria of less than 22.5 had an average return of +45%. The list of companies with a Graham ratio higher than 22.5 had an average return of +32%. As a result, by simply applying the Graham ratio criteria to our list, we were able to enhance investment returns by +13%. The results can be seen in the following link.
Disclosure: The author is long WAG, UNM, AMAT, ABM, MCY.