Method of Stock Analysis as Introduced by Benjamin Graham

Are you considering investment as a viable financial move for your future? Today, more people see the appeal of investing in stocks. The investment world is not only filled with middle age people. The youngsters are also start building their portfolios early on. Despite the increase interest in stock investment, not all investors manage to grow their portfolio values to the state that they had expected. There are in fact investors who experience loss because they did not make the right choices.

Upon a first glance, you might think that stock investment is pure gamble. However, that is not true at all. Up to certain level, the market is predictable. Prior to purchasing stocks, you can actually try to predict the return of investment as well as the risks of purchasing those stocks. Such analysis is really important because only then you make the best financial decision. There are various formulas that are often used by investors, but the most widely used one is Benjamin Graham’s.

Graham was an economist and investment mentor for famous figures such as Warren Buffett. His contribution to the economy development was huge that people still apply his principles in this modern era. He taught investors about the importance of deciding stock value or otherwise known as stock analysis. When knowing the value of a stock, investor can decide how much money they are willing to spend to purchase it. Not only that, the valuation can help investor predict how much it can grow in the future. 

There are two central concepts in Graham’s stock analysis that you should keep in mind. First, stock valuation is combining quantitative and qualitative data. It is not enough to have the numerical data when valuating stocks. You have to think about aspects that may not be visible but also play role in the stock value. Second, the stock value does not appear in one absolute number. It cannot be narrowed down into a specific number, but instead shown in a range. In the process of evaluating a stock, you are making quantitative analysis on the current economical value. The quantitative data is then used to develop narrative of the value development in coming future, whether it will be going up or down.

In order to determine that the stock you are about to buy has enduring value, you need to consider the following facets.

1. Current ratio

To calculate the current ratio, you need to divide the value of current assets by current liabilities. It shows the company’s capability in paying obligations which are short term in nature, usually within the span of a year or so. The industry standard will recommend you to choose companies with current ratio at least at 1.50. It will be better if the ration is higher than said number.

2. Quality rating

It is also known as credit rating which means the assessment of a company’s credit worthiness. This rating shows how well the company will be able to pay loan that is assigned to it. Some people would automatically look for the highest rating company, but when considering growth, they will find that company with high growth rates tend to only have higher than average rate at best. It is in fact okay to invest in companies with only average quality rating. If you are using the S&P rating system to assess this particular aspect, you better look for companies with quality rating higher than B+.

3. Debt to current asset ratio

The ratio can be defined as division of total liabilities (debt) by the total assets owned by the company at the moment. This ratio shows the proportion of assets that are financed by taking debts. Ratio that is less than 0.5 implies that the assets are mostly obtained from equity. Meanwhile, if the ratio is higher than 0.5, most of the assets are financed by liabilities. According to Graham’s advice, the maximum ratio that you should tolerate is 1.10. If the ratio shows number higher than that, the company as too much debt loads to payoff.

4. Price to book value 

This value is obtained by dividing the current market value of the stock with the book value of its equity. The market value can be calculated by multiplying stock price with the number of outstanding shares. Meanwhile, the book value is total net assets owned by the company. This data is a great indicator for intrinsic value of company. It is better to purchase stock from a company with price to book value lower than 1.0. It means that the shares is still lower than the assets.

5. Growth of positive earnings per share

It can be defined as the rate of company’s profitability growth per unit of its share. The higher rate of earnings per share growth means that the stock is more promising than if it is lower. You need to see the rate for five years back. It should grow continuously and not experience deficits at all. It can be decided by checking if the earnings of recent years has increased compared to they were five years ago. Companies that have experienced deficits in the last five years tend to be a high risk companies.

6. Ratio of price to earnings per share

This ratio is obtained by division of company’s recent stock price by its earnings per share. The earnings per share itself can be calculated by dividing the subtraction of preferred dividends from company’s net earnings by the outstanding number of shares. It is recommended to invest in companies with price to earnings per share ratios lower than 9.0. This means that you should look for companies that sell their stocks at affordable price points. However, you should always consider the growth factors because companies with affordable stock price tend to not have high growth.

7. Dividends

Dividend means the distribution of company’s earnings to its shareholders (by class) according to the board of directors. You must look for companies that regularly pay dividends to its shareholders. That way, when you are still waiting for the stock value to increase (this process can happen very slowly), you are still collecting dividends at the mean time.

There are several types of strategies suggested by Graham utilizing the evaluation method that has been explained. The strategies differ in the amount of efforts pour into them. 

1. Index fund investment

If you do not really see investment as main source of income and instead want to utilize it as a station to keep your fund, you might want to employ index fund investment strategy. It requires little to no effort at all from your part. In this scenario, you only invest in stocks that only consist of one index. You are recommended to invest in reputable index fund. In terms of profitability, you will gain very low profit but it is generally safer.

2. Defensive stock investment

The second strategy, which is defensive stock investment, is perfect for people who are willing to take small risks but overall does not want to exercise too much effort into their investment. Defensive stock is a great choice because it offers stable earnings for the shareholders regardless of stock market condition. The reason is because the company has an established market and thus the demand to their products tends to be stable. The profit is low, but definitely higher than index fund investment. 

There are several criteria that Graham specified to determine defensive stocks, including:

Annual sales higher than $100 million

The maximum debt to current asset ratio is 0.5

There is at least one-third increase in the per share earnings within the last 10 years.

3. Enterprising stock investment

If you want to earn a lot more profits and are willing to shoulder higher risks, then this strategy is great for you. As an enterprising investor, you need to exercise more efforts into your portfolio. This means that you have to perform market research, constant portfolio revisions (if required), and individual investments selection. The monitoring must be done as often as possible.

There are several criteria that Graham had explained to determine enterprising stocks, including:

The company had not experienced deficit within the last five years.

There is a growth of earnings from year to year.

The company actively pays dividends.

4. Net-Current-Asset Value stock investment

This particular investment strategy is the most famous one taught by the master. It is a recommended strategy for people who are willing to pour extra efforts into their portfolio management. You get the value by subtracting the current assets by total liabilities. In this method, you will opt to purchase stock that is priced below this value. You only need to pay small sum and see if the company grows. However, you have to understand that in this high risk investment, you must diversify your portfolio as well as continuously track the progress of your shares.

5. Special situations investment

This investment only happens in certain situations such as small firm acquisitions, arbitrary operations, as well as the division of public utility holding firms due to certain legislation. If you have fund to invest on these stocks, then you should take advantage of it.

As shown in this passage, in addition to making analysis on the available stocks, you also need to understand your own stand. This includes your financial capability as well as risk tolerance. If you do not think that you can handle some risky investment move, then you better choose strategy which offers lower risk. You should also take into account your own financial objectives. That way, you will have more cohesive stock investment plan.


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