Benjamin Graham Value Investing- Filters to find undervalued stocks

Value Investing-Filters to find undervalued stocks

Benjamin Graham was an American economist, investor and professor. He is known to be the "Father of Value Investing". His investment philosophy is more leaned towards fundamental analysis, buy & hold investing, minimal debt, mass-psychology, concentrated diversification, and buying under the margin of safety. These concepts are still relevant and popular among the ace investors including Warren Buffett and Irvine Kahn. He also coined a term that is Mr. Market. 

Mr. Market is a person, who welcomes you (investors) as soon as market opens up daily in the morning and offer companies on sale for a certain price distributed as 'Common Stocks'. Investors are free to agree with him or ignore him. He asserted that every investor in Stock Market should consider himself as they are completely in business with Mr. Market. Sometime, Mr. Market can offer a company at a very discount price to its actual value while sometime, he overprices the company. Under-pricing of companies due to market volatility and Mr. Market auctions creates a lot of opportunity for investors to buy value companies at a cheap price. This phenomena is known as "Margin of Safety".

"Margin of Safety" theory of Ben Graham states that one should always consider those companies to investing that are selling at heavy discount (at least 50%) to their intrinsic value. Such companies should also offer great value to its customers and other associated operational stakeholders while providing regular dividend income to its promoters and investors. Ben Graham was a strong supporter of 'Dividend Pay-outs'. He usually suspects the companies, which make a good amount of earnings but do not distribute the profits into investors as dividends and keep all the profits as "Retained Earnings". Such earnings are kept on the book to show investors that companies will use such funds to grow company's product lines and expand other business related operations. 

All of the above investing concepts are still relevant in today's financial markets around the globe. In the below article, we will study some of the important formula / filters to find undervalued stocks that one should consider in his/her investing style. 

** Investment is totally is qualitative field; It does not require a very hard maths from you. Fifth grade maths would work excellent. Let us go-

Filter #1: Sectors to focus

Before jumping to companies / tickers, one should consider the selection of sectors. Value investing formula generally works well for all types of companies except the technology firms. So, investors should look for discounted companies besides the technology enabled sector. While choosing a sector, you should only focus to underlying companies. In Investing, "One should not compare Apples with Oranges". 

Filter #2: Company's Sales 

Second important filter for finding value companies is company's Sales Number. Higher sales represents longevity of business and sustainable business operations. Continuous higher sales number over the couple of years all represents the high brand-value. Investors should always compare the companies sales numbers over the past ten years at least and analyse the sales numbers of the competing companies in the picked-up industry / sector. 

Filter #3: Current Ratio

Current Ratio is the ratio of current assets to current liabilities. It represents the company's ability to pay off short-term debts or dues within one year. It is generally considered that if a company is not able to pay-off its short-term debts, eventually it will default on its long-term debt too. such companies are categorized as struggling businesses. For passing this filter, 

• Current Ratio >= 2; 
• Current Ratio less than 2 can be considered for telecom or other utilities related businesses

Filter #4: Long-term debt to Net Current Assets

Net Current Assets is difference between current assets and current liabilities. These include cash, cash equivalents, marketable securities, and account receivables. Higher Net current assets represents strong position of business to pay off its short-term debt. To qualify this filter, a company must have

• Long-term Debt <= Net Current Assets; 

Filter #5: Long-Term EPS growth

EPS (Earning per share) is the ratio of net profit and total outstanding shares. A strong fundamental company should strong EPS over the years. For assessing long-term EPS growth, time frame for assessment should be ten years at least. If a company is showing strong sales number over the years; however, if the sales is not turning into strong earnings then it is not advisable to consider such businesses for investment. Hence,

• Long-term EPS growth >= 30% (Compound Growth Rate) and there should be no negative annual EPS in the last 5 years;
• Long Term EPS growth < 30% (Fail)
• Long Term EPS growth >=30%; but showing up negative annual EPS in any of the last five years (Fail)

Filter #6: Price-to-Earnings Ratio

P/E ratio is one of the most used indicator to gauge overvalued or undervalued stocks. It is a ratio of price per share to earning per share. If price is very high in comparison to the earnings, then stock is considered overvalued. As per value investing, investors should look for margin of safety. To pass this filter, a stock's P/E ratio should be less than or equals to 15. P/E ratio greater that 15 is considered to be overvalued. 

Here, to minimize the misleading number of earnings, investors should consider the average of last three year's earnings for the calculation.

Filter #7: Total Debt-to-Equity Ratio

A D/E ratio represents how much debt a company has as compared to its assets. In more simple terms, Short-term + long-term debt and shareholder's equity is used to finance the overall company's assets to generate profits. Debt is the liability that every business has to pay back at every cost. Hence, Shareholders receive the value at last. Higher debt reduces the rewards to invested shareholders. That's why, High D/E ratio indicates that the respective company is debt-driven and all its earnings will go in paying its debt. To qualify this filter, business must have

• Industrial companies- D/E Ratio <= 100% (Pass)
• For Utilities, Telecom, Railroads, Infrastructure- Lon-term Debt to Equity Ratio<=200% (Pass)

Filter #8: Continuous Dividends Payments

A value company must reward its shareholders by paying out the dividends. Dividend is the percentage of retained earnings paid to the shareholders. Shareholders can use this money to reinvest in the purchase of the shares resulting in further high stock price. 

Filter #9: Price-to-Book Ratio

Book Value is the total value of a company in accounting terms. It is sometimes refer to the liquidation value. However, a company's value would be much higher than the book value. It is obtained by subtracting the total liabilities from total assets. To qualify this filter, stock must have

• P/B * P/E <=22 (Pass)
• P/B * P/E >22 (Fail)

In the above article, we have gathered all the major filters that one should consider in finding the undervalued stocks. However, it is advised that after shortlisting the stocks based on the above criteria, one should also consider to analyse the overall business outlook which majorly comprised of finding the competitive business advantages over its industry's competitors. 

For more such useful information, stay tuned to WoodWallet. If you want information on any specific topics related to stock investment or personal finances, please keep us posted.