Seeking Alpha

Updating Benjamin Graham's Intrinsic Values And Evaluating Financial Enterprises

by: Serenity
Summary

Warren Buffett wrote in 2008 that he'd been exclusively following Benjamin Graham's investment framework for 57 years.

Graham's Intrinsic Value formulas allow for P/E ratios of 30 - or more - based on current bond yields.

Utilities and Financials - unlike Industrials - are evaluated using Total Assets and Equity÷Debt, instead of Sales and Current Assets.

Benjamin Graham was a scholar and professional investor who mentored some of the world's most renowned investors, including Warren Buffett, Bill Ruane, Irving Kahn, and Walter Schloss.

Warren Buffett - in his 2008 foreword to Graham's book Security Analysis - wrote:

"My intellectual odyssey ended, however, when I met Ben and Dave, first through their writings and then in person. They laid out a roadmap for investing that I have now been following for 57 years. There's been no reason to look for another."

Previously, we discussed Investing For Beginners With Benjamin Graham.

Today, we'll look at some of the more advanced applications of Graham's 17-rule Value Investing framework.

Updating Graham's Intrinsic Value formulas

Graham recommended a P/E ratio no higher than 13.3 based on an AA bond yield of 7.5%.

From Chapter 14: Stock Selection for the Defensive Investor of The Intelligent Investor:

Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/price ratio - the reverse of the P/E ratio - at least as high as the current high-grade bond rate. This would mean a P/E ratio no higher than 13.3 against an AA bond yield of 7.5%.

Based on the same principle, a defensive investor today could consider stocks with P/E ratios up to 30, since 10-year AA corporate bond yields are around 3.3%.

Adjusting Graham's framework to P/E ratios of 30 instead of 15 (all else being equal) would involve the following:

Graham Number = Square Root of (22.5 x EPS x BVPS)

30÷15 = 2
√2 = 1.41

We would need to multiply the Graham Number of a stock by 1.41 to adjust it to a P/E of 30.

Intrinsic Values for Enterprising grade stocks can be similarly adjusted.

However, Intrinsic Values for NCAV (Net Current Asset Value or Net-Net) grade stocks cannot be adjusted thus. NCAV values are calculated using asset values alone, which - unlike earnings yields - are not dependent on bond rates.

Note: Since the Graham Number is designed to balance Earnings and Assets, stocks with P/E values higher than 30 could clear Graham's rules too if they have lower P/B values.

Evaluating Public Utilities and Financial Enterprises

From Chapter 14: Stock Selection for the Defensive Investor of The Intelligent Investor:

1. Adequate Size of the Enterprise - not less than $50 million of total assets for a public utility.
2. A Sufficiently Strong Financial Condition - For public utilities the debt should not exceed twice the stock equity (at book value).

#1 evaluates to about $250 million in Total Assets today, when adjusted for inflation.

From the same chapter, under the subheading The Public-Utility "Solution":

We exclude one criterion from our tests of public-utility stocks-namely, the ratio of current assets to current liabilities. The working-capital factor takes care of itself in this industry as part of the continuous financing of its growth by sales of bonds and shares. We do require an adequate proportion of stock capital to debt.

From the subheading Investing in Stocks of Financial Enterprises:

We have no very helpful remarks to offer in this broad area of investment-other than to counsel that the same arithmetical standards for price in relation to earnings and book value be applied to the choice of companies in these groups as we have suggested for industrial and public-utility investments.

Utilities and Financials - unlike Industrials - are therefore not evaluated using Sales, Current Assets or Current Liabilities. Utilities and Financials are instead valued using Total Assets and Equity÷Debt.

Finding Graham Stocks Today

In 2018, the distribution of U.S. stocks fully compliant with Benjamin Graham's investment framework is as follows (by category):

Utilities and Financials

  • 33 Defensive

Industrials

  • 07 Defensive
  • 30 Enterprising
  • 35 NCAV (Net-Net)

Value Investing 101 provides a list of standard preloads that can be quickly applied to Serenity's Graham screeners to list these stocks.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.