During the great depression, one of the most famous investment authors was writing his prized work, Security Analysis.
Although some call this book the bible of value investing, many have a difficult time deciphering the financial code that Graham discusses throughout the book.
As a financial analyst, Graham developed a new ratio that many have deemed The Graham Number.
One of Graham's prized pupils was a boy from Omaha named Warren Buffett.
Before Buffet amassed 44 billion dollars from reading Graham's books, Buffett worked for Ben Graham in New York.
During this time, Graham and Buffett didn't have the luxuries of immediate stock screening search results from the internet.
Instead, they faced monstrous books that housed all the newly printed data from Wall Street.
Each page of these mammoth books had a line entry about each company and their corresponding financial data on the stock exchange.
For example, if they wanted information about the Ford Motor Company, they might turn to page 643 and find the Book Value, the EPS, the Debt to Equity Ratio, the average volume, and many other numbers and ratios.
Since sorting through all this data was extremely difficult for Buffett and Graham, Ben Graham developed a simple formula to quickly separate the cream from the crud.
In order to filter the stock results, Graham decided to focus on three important aspects; price, earnings, and Safety.
Price This was probably the easiest piece of the puzzle because the price was nothing more than the market price the company was trading for on the stock exchange.
Like any investment, the price you pay has an enormous impact on the value you get.
For example, few people would pay $1,000 for a pair of jeans.
Most won't do this because the purpose of jeans is to cover your legs and to look appropriate.
This can usually be accomplished for $50 or less.
For the person who paid way too much, they have less money to allocate to other assets.
This idea is no different for buying stocks.
If you pay too much, your return will already be handicapped by the overvalued price you paid.
Earnings Now if you had the chance to buy jeans with $10 in the pocket, would you rather buy the jeans for $1000 or $50.
Obviously the later would give you a 20% return on your investment.
Whereas the first would give you a 1% return.
You see, when we compare the earnings (or profit) of a business, the price is very important.
What I just did was compare the price to the earnings.
In stock investing there's an important ratio called the Price to Earnings Ratio that does exactly that.
It takes the current market price and divides it by the company's profit (or earnings).
The P/E ratio was clearly something that held a lot of value for Benjamin Graham and Warren Buffett.
When they were trying to find companies in these massive stock books, they always looked for companies with a P/E less than 15.
That means, at the most, they were willing to pay $15 dollars for a stock that would earn $1 annually.
Margin of Safety Benjamin Graham felt that the safety of an investment was directly related to the price an investor paid for the assets the company already owned.
The difference between a company's assets and liabilities is called its equity.
Graham believed that if a company's equity was equal to its market price, the company possessed no risk to the potential investor.
The reason Graham felt this way is because if the company would simply end its operations tomorrow, it could be sold for the same price an investor paid for it.
When a company is divided into smaller pieces, or shares, the equity no longer called equity.
Instead it is called book value.
So, as you can see, the price to book value ratio is really important because it shows an investor how much margin of safety, or risk, is associated with any given stock pick.
If the P/BV ratio is a 1.
0, that means that for every 1 dollar you spend buying a particular stock, it possesses 1 dollar of equity.
When Graham and Buffett would peruse these massive stock books, they always tried to find companies with a Price/Book less than 1.
5.
By doing this, they felt their risk in the company was minimized.
With this ratio, they were essentially saying they wanted $1 of equity for every $1.
50 they spent buying the stock.
Putting it all Together Now that we understand the key terms that Graham and Buffett consider important, let's put them together.
We know that Graham considered a P/E ratio below 15 a decent buy and a P/BV below 1.
5 less risky.
As a result, he simply multiplied these two numbers together to get the Graham Number.
If we take the two highest values for each variable (P/E and P/BV), the product is 22.
5.
As a result, Graham would multiply the P/E by the P/BV, and try to find companies below 22.
5.
Companies that met this gate were paying a healthy return for the price and they also possessed a nice margin of safety.