A comment I included in the updated intrinsic value formula post by Ben Graham about his “strict” standards for judging financial strength made me wonder: what are those standard exactly? So I rooted out my trusty copy of Intelligent Investor (see Chapter 14) to find out:
- Size of enterprise
Obviously this must be arbitrary, but the objective is to consider only the more prominent companies. Jason Zweig suggests in his notes that, as of 2003, Graham’s original figures would translate to at least $2 billion. Alternatively, you could consider companies that rank within the first quarter or first third within their sectors. - Sufficiently strong financial condition
Here BG recommends that current assets should be at least twice current liabilities. Additionally, long-term debt should not exceed net current assets (working capital). This is somewhere between rigorous and demanding. - Earnings stability
Some earnings in each of the past ten years, which means no unprofitable years in ten. - Dividend record
He suggests buying only companies that have paid continuous dividends for at least the past twenty years. This requirement–I am confident–would be met by most of the shares in my portfolio. - Earnings growth
Here he recommends a minimum increase of at least one-third in per-share earnings in the past ten years, using three-year averages at the beginning and the end. I will just look for the one-third increase! - Moderate price/earnings ratio
Current price should not exceed 15 times the last 3 years’ average earnings. I think that the average P/E for the S&P 500 is 15 and so this is another percentage play–keep your selections to cheaper than the average and you get a better than evens chance of better returns; value investing at work? As an aside here, BG later suggests that the earnings yield, which is the inverse of the p/e ratio, should be at least as high as the current high-grade bond rate (10-yr UK gilt yield = 2.69%). - Moderate ratio of price to assets
Current price should not exceed 1.5 times book value.With regard to numbers 6 & 7, he suggests a rule of thumb that the product of the PE ratio and the of price to book value should not exceed 22.5. (22.5 corresponds to 15 * 1.5).
I am still interested in buying more IBM and so I will now try to put it through the Graham mill to see whether it emerges intact.
- Size of enterprise
Easy. By a mile! - Sufficiently strong financial condition
Here, using Morningstar’s figures, I get a current ratio of 1.3, which falls short of the ambitious 2. Secondly, long-term debt does exceed working capital (32m vs 11m). Disappointing. - Earnings stability
Definitely for five years. Morningstar, sadly, won’t show me ten but I think I can safely assume that IBM is ok on this front. - Dividend record
Exemplary. Big Blue has just announced its 19th consecutive dividend increase. - Earnings growth
Again, I can just go back the five years provided by Morningstar, but there is nearly earnings per-share 50% growth in those years alone. - Moderate P/E ratio
The current price is just 12.9 times last year’s earnings. The earning yield, that is the inverse of the P/E, is 7.75%, which is much higher than the 2.69% 10-yr gilt yield. - Moderate ratio of price to assets
Current price to book value is 8.8, which massively exceeds 1.5. With regard to the rule of thumb, 8.8 X 12.9 is 113.5, which is also much higher than the recommended 22.5. I think, however, that price to book value is meaningless for a an IT services/consultancy company like IBM. Jason Zweig notes that, in recent years, an increasing proportion of the value of companies has come from intangible assets, such as, franchises, brand names, patents, goodwill and trademarks–factors which are included from book value. Consequently book values today tend to be much higher than they were in Graham’s time.
Overall IBM passes five out of seven. I am not worried by the price to book value fail, because I do not think that this is a relevant metric for a company like IBM, which produces more patents every year than any other company. The financial condition metric is more interesting; the current ratio is not far out (1.5 is permitted for enterprising, rather than defensive investors, but it would be preferable if debt were reduced. Although, again, that is arguable because I think that a lot of the debt is being used to repurchase shares at prices that the board consider too low. It is also, perhaps, a prudent time for companies to take on long-term debt because interest rates are so low. So does that make it less of a worry?
I like these guidelines–they are a useful tool to help eliminate dangerous investments and, in future, I will use them in tandem with the intrinsic value formula. Additionally, there is a Graham number formula, which I will also investigate in a future post to complete the BG hat-trick for defensive stock selection.
Disclosure: Long IBM
Disclaimer: This post is not a recommendation to either buy or sell. Please consult your investment advisor.