To maximize the returns of investors and reduce its related risk, Graham developed 10 sound principles for analyzing a company’s fundamentals and its future scenario.
1. Earnings to price yield should be at least twice the triple-A bond yield – The earnings yield is the reciprocal of the price to earnings ratio. Graham recommended that the yield on the earnings should be at least twice the AAA bond yield. For eg:- if the bond rate is 10% then P/e of the company should not be more than 5.
2. A price to earnings ratio should be lesser than 40% of the highest price-earnings ratio the stock had over the past five years – Graham believed that the stock selection should not be based solely on the current price to earnings performance of the company. On the contrary, the value of the current P/e should compare with the past P/e of the firm to understand the future potential earnings of the firm.
3. Dividend yield should be of at least two-thirds of the triple-A bond yield – When a corporation earns the profit or surplus, it can either re-invest its earnings in the business or distribute among its shareholders. The portion of the earnings distributed to the shareholders is called a dividend. A flourishing company is one which can pay dividends regularly and generally increase the rate as the time lapses. Graham recommended that dividend yield should be at least 2/3 of the bond yield. Since the bond is considered as a safer and steady source of earnings. Despite this. the investor would invest in a stock and should get risk-reward.
4. A stock price should be lesser than two-thirds of tangible book value per share – The price to book value ratio states the company asset value. If the stock price is less than the 2/3rd of tangible book value per share then it is considered as an undervalued and investor should also have a margin of safety.
5. A stock price should be lesser than two-thirds of net current asset value (current assets less total debt) – According to Graham, net current asset value (NCAV) is the basic key of the liquidating worth of the enterprise. Liquidating value of the enterprise is the money that the owners could get out of it when the company is liquidated. It is calculated as under: Net current asset value= Current assets- (long term as well as short term liabilities+ preferred stock). According to this principle, a stock should be bought when its market price is lesser than two-third of its net current asset value. This would mean that the buyer would pay nothing at all for the fixed assets, such as, land, buildings, machinery etc., or any goodwill items that might exist
6. Total debt should be lesser than the book value – The debt means the total amount of money borrowed by a company from outside parties. It includes both, short term as well as long term liabilities owned by a company whereas Book value of firm means the excess of assets over total debt and preferred stock. This principle states that the debt should not exceed the book value or the debt to equity ratio should be lesser than 1 which gives a clear indication that the company is financially strong and the lower amount of debt can avoid financial problems on the company at the time of depression. If the firm has higher debt about book value, then earnings would be used to pay off debt and the excessive debt could also lead to bankruptcy. Thus, the companies should have a sound asset base to pay off their debt
7. Current ratio (current assets divided by current liabilities) should be greater than two. Current ratio determines how many cash in assets are likely to be converted to cash in one year to pay off the debts that become payable during the same year. If the current ratio is greater than 2 then the company has enough assets that will convert into cash to pay its debts which is a good sign for a company to carry out their operations.
8. Total debt should be lesser than twice the “net current asset value” – According to Graham, “Whenever a bond is completely covered by net current assets, its safety is thereby guaranteed. Thus, the net current assets of the company should be sufficient enough to provide a complete coat to the total debt of the company.
9. Earnings should have shown a compounded annual growth of at least 7% in the last ten years – Graham believed that a continuous increase in annual profits give the signal that the company was taking necessary steps to differentiate from their competitors which helps the investor to gain the confidence to get better results in the future than had been accomplished to date.
10. Stability of growth in earnings i.e. there should be no more than two declines of five per cent or more in year-end earnings over the most recent ten years – If the earnings of a company are stable, it gives confidence to an investor that his/her investment is safe. Stable earning company has an advantage to less likely shake with earnings announcements that surprise investors.
The above-mentioned principles are distilled based on Benjamin Graham’s understanding of six decades during his last years. These ten criteria help the intelligent investor to pick value stocks from the chaff of the market.