Explained: Benjamin Graham’s Seven Criteria for Selecting Value Stocks

3 minutes read

The Godfather himself, Benjamin Graham has laid out the principles for investing in stocks and you should be paying attention. The late Benjamin Graham is considered one of the best value investors to ever exist. Ask Warren buffet if you don’t trust us. Benjamin Graham is also the author behind ‘The Intelligent Investor’- the book your favourite stock expert probably goes to sleep with. He is known to be one of the earliest proponents of the value investing strategy back in the 1920s, and this is why you should care.

Value investing is an investing strategy that is based on the fundamentals of a company’s business rather than the market factors affecting it In simple words, it suggests picking stocks that appear to be trading for less, but actually have a high intrinsic or book value. This strategy gives you the opportunity to basically invest in a  company at a discounted price because the value of the company is bound to correct to the level implied by its business fundamentals.

Here are at least 7 principles/criterion from Benjamin Graham’s checklist to help you identify value stocks.

Benjamin Graham Investing Principles

1. Quality Rating

When picking a stock, it’s not necessary to find the best quality companies. Even the average ones or better can have a high value. To evaluate quality, use a simple trick: look at the S&P Earnings and Dividend Rating of the company. Graham suggests that any company with a rating of ‘B’ or better is a safe choice.

In other words, a company doesn’t necessarily have to create waves in the market or catch investors’ attention with a very high-quality rating. However, it is important that the company has a good track record (history) and shows signs of growth (future). Companies with a rating of ‘B’ or higher are likely to be of more value than the ones below.

2. Financial Leverage

Avoid companies that have debt much higher than their current assets. A company with a low debt load is more likely to be sustainable and wouldn’t need to give away its fixed assets to service the debt, especially in turbulent times. Graham advises selecting companies with debt not exceeding 110% of net current assets (for industrial companies). 

The value investing formula is: Total Debt to Current Asset ratio less than 1.10. This data can be found on multiple sites.

3. Company’s Liquidity

In alignment with the previous point, a company’s ability to pay is denoted by the current ratio: the ratio of Current Assets to Liabilities. Value investing encourages you to select a company with current assets at least 1 ½ (or 1.50) times its current liabilities. The ratio indicates the company’s ability to pay short-term liabilities.

4. Positive Earnings Growth

Graham keeps this point self-explanatory. Select Companies that have positive earnings per share growth. Use the last 5 years of the company’s earnings as the track record. Companies that have increased earnings year after year with no deficit are a safer choice. Using this principle, you minimise your risk by investing in the safest companies in a particular industry or sector.

5. Price to Earnings Ratio

As per Graham, cumulative growth for the last few years needs to be taken into account while investing in a company. Earnings per share (EPS) indicates the company’s profitability. Price to Earnings Ratio (P/E) is the ratio of EPS to the company’s share price.

The trick here is to invest in companies with a P/E Ratio of 9.0 or less. Companies that sell for low prices compared to EPS are often undervalued, meaning the value should increase.
Note: This criterion doesn’t take into account high growth companies and that P/E ratios differ by sectors/industries. Hence, always look at the P/E ratios of the company’s competitors before deciding.

6. Price to Book Ratio

Find companies with a price to book value (P/BV) ratio less than 1.20. P/BV ratios are calculated by dividing the current share price by the most recent book value per share for a company. Book value provides a good indication of the underlying value of a company. Investing in stocks selling near or below their book value makes sense from a value investing perspective.

7. Dividends

Another simple and self-explanatory principle, courtesy of the investment guru.  Invest in companies that give back, which is also a principle that Warren Buffet closely follows. Companies that pay dividends will help you create a passive income. 

In 2021, when the volatility of stocks is un-understandable and likely to be confusing for first-time investors, it would be wise to learn a bit more about this strategy. Many retail investors have made mistakes that can’t be corrected due to boarding hype trains and watching other investors, without doing their due diligence. While value investing, the risk is lower by default as it is a more informed way to invest.

Related Posts

Why Big Tech Needs to be a Part of Every Indian Portfolio

Rukesh Reddy, Director of Digital Transformation at Citibank in New York, talks about why every investor needs to lean heavy on software companies while building an investment portfolio.

What is the W-8BEN form for foreigners investing in US stocks?

If you generate income in the USA and are not a US person for tax purposes, you need to use the W-8BEN form to establish your foreign status. The W-8 BEN form allows tax exemptions and categorizes you to be taxed appropriately as a foreigner.

What Are The Macroeconomic Factors Affecting the US Stock Market?

You may have heard and read of macro-economic factors and data making the headlines and affecting the stock market. We will try to understand what these factors are and go through a few of them in this article.