Finding Undervalued Stocks The Benjamin Graham Way

First, list all stocks with Price/Earnings ratios below 9. Note: Graham was writing in 1970 when P/E’s as a whole were not as elevated by technology stocks as they are today. Readers who are less risk-averse or who just want to consider a wider range of stocks may wish to vary the P/E in order to see what comes up — perhaps up to 80 percent of the average P/E of the S&P 500 would be a good start. Currently the operating average is around 18 and 85 percent of that figure is just over 15. Graham did not state if he was using a Trailing or Forward P/E ratio, but most likely he was using Trailing P/Es. I personally prefer to use Forward P/E ratios, especially if they are significantly lower than the Trailing P/E as this implies expected earnings growth and therefore possible increase in the stock price.

Once we have a list of stocks meeting the P/E criterion, we consider the financial condition of each stock, referring to the most recent balance sheet: Initially, Current Assets must be at least 1.5 times Current Liabilities. This can also be gleaned via a stock screener by displaying stocks with “Current Ratio” >= 1.5. Total Debt must not be greater than 110% of Net Current Assets (i.e. the sum of Cash & Cash Equivalents, Inventory, Accounts Receivable). Looking further back, we need to find evidence of Earnings Stability, with no deficit in the last five years, i.e. no evidence of an annual loss. Additionally, evidence of earnings growth over a five-year period is a must. This can simply be the consideration, for example, that 2004 earnings were greater than 2000 earnings.

There should be some current dividend payout. Finally, the current price of the stock should be less than 120% of the NCAV per share or Graham’s Number. Where to find this number? From the balance sheet, subtract Total Liabilities from Current Assets, and divide the result by the number of shares outstanding. Assuming you have a positive number that is greater than zero, the stock’s price should not be greater than 120% of this number.

Source: Value Investing Portal