5 Essential Rules to Master Graham’s Enterprising Investment : The Complete Guide
When it comes to the world of investment, the name Benjamin Graham is widely recognized, particularly through the endorsement of Warren Buffet. Even though Graham’s books were written decades ago, they continue to serve as a valuable and insightful guide for selecting stocks. In his writings, Graham outlined an algorithm consisting of eight key points that can be utilized to identify what he referred to as “Defensive” Stocks.
According to Graham, defensive stocks are considered to be the highest quality stocks and are strongly recommended by him. On the other hand, stocks with greater risks are classified as “Enterprising.” In order to qualify as a defensive stock, certain requirements need to be met.
These requirements include the following:
- 1-A. Current assets should be at least 1.5 current liabilities.
- 1-B. Long-term debt should not exceed 110% of net current assets.
- 2. Earnings stability: No deficit in the last five years covered in the Stock Guide..
- 3. Dividend record: Some current dividend.
- 4. Price: Less than 120% net tangible assets - Serenity Number
Graham’s Rule N°1 : Asset/Liabilities
Rule number 2 is closely connected to the Book Value, which determines whether the balance favors Assets or Liabilities. This rule has been formulated in two different ways, depending on the sector.
\( \text{Rule 1A}=\frac{\text{Current Assets}}{2*\text{Current Liabilities}} >0.75\)
\( \text{Rule 1B}=\frac{\text{Net Current Assets}}{\text{Long-Term Debt}}>0.9 \)
The alternative for Utilities and Financials is :
\( \text{Rule 1B}=\frac{2*\text{Equity}}{\text{Debt}}>0.9 \)
Graham’s Rule N°2 : Earning Stability
When it comes to Defensive companies, Graham suggests that they should have a track record of consistently making profits over the last ten years. This means that they've managed to maintain a positive earnings trend over a significant period of time.
By adhering to this criterion, Defensive companies demonstrate their ability to weather economic storms and remain stable in terms of financial performance. It's like having a strong shield against market uncertainties.
\( \text{Earning Stability}=\text{10%}*\text{Continuous Years of Positive Earning} >\text{50%}\)
Graham’s Rule N°3 : Dividend Record
Just like Rule N°3, another important criterion for a defensive company is its consistent payment of dividends over a period of at least 20 years. This means that year after year, the company has been sharing its profits with its shareholders through dividend payments.
By fulfilling this requirement, a defensive company showcases its commitment to providing a steady income stream to its investors. It demonstrates financial stability and reliability over an extended period of time.
\( \text{Dividend Record}=\text{5%}*\text{Continuous Years of Paid Dividend} >\text{5%}\)
Graham’s Rule n°5: The Serenity Number
In addition to the criteria of financial stability and growth, Graham also emphasized the importance of considering the price of a company. He believed that a comprehensive analysis must take into account not only the company's fundamentals but also its valuation.
Graham's quantitative criteria for Enterprising investment are the lower of 120% of Tangible Book Value Per Share (TBVPS), or a Price-to-Earnings (P/E) ratio of 10. With a derivation similar to the Graham Number, we get the following Intrinsic Value calculation.
\( \text{Serenity Number}=\sqrt{12*\text{EPS}*\text{TBVPS}} \)
\( \text{Serenity Number (%)}=\frac{\text{Serenity Number}}{\text{Stock Price}} \)
The Graham Number holds an intriguing significance. It can be defined as the intrinsic value of a company, determined by considering both its book value (assets) and its earnings. In the case of Apple, Graham indicates an intrinsic value of 18.91 USD. If the stock price exceeds this value, it suggests the company may be overvalued