Key Takeaways

● Graham is widely known as the father of value investing

● Graham advises emotional stability as an important tool to stay cool during market fluctuations

● Graham created the Graham Number to measure a stock's fundamental value

Benjamin Graham, the economist, is widely known as the "father of value investing" and "dean of Wall Street", one of the greatest investors in the 20th century. He was also recognized as Warren Buffett's mentor.

In his book The Intelligent Investor, Published by Harper Business; Subsequent edition (February 21, 2006), Graham advised investors to keep a margin of safety with the stock market, avoid elusive financial products, schemes, and investment vehicles, and ditch high-risk stocks and bonds.

Graham also created the Graham Number, a metric that combines various indicators to measure whether a company's stock price is reasonable or not. （What Is the Graham Number? CAMERON WILLIAMS wrote in June 27, 2022, on www.thebalance.com）

Mr. Market

Graham created an allegory of Mr. Market, an imaginary character, to demonstrate his value approach better.

Suppose Mr. Market is your business partner. He shows up every day at your office, offering to buy you out or sell his share of the company at wildly different prices, which are based not on the actual performance of your partnership but on his unstable mood.

Sometimes, Mr. Market's idea of value seems reasonable and matches your view. However, his confidence or fear may get out of control very often, resulting in offers with ridiculously high or low prices. You may never be sure what mood you will find him in, but you can be sure that Mr. Market will be back again with a new set of prices tomorrow, regardless of whether you trade with him today. （Chapter 8, The Intelligent Investor, Published by Harper Business; Subsequent edition (February 21, 2006）

Graham cautioned investors against letting Mr. Market's daily communication determine their view of their holdings. Instead, he emphasized the importance of making their own judgment.

Conclusion:

Today's successful value investors generally embrace the "Mr. Market" fable: trying to be emotionally stable and to stay cool to market fluctuations. Market lows and highs can be signals for sensible buy and sell decisions. But in other circumstances, investors do not have to follow the market updates closely. Instead, they shift their attention to dividends and a company's performance.

The Graham Number

Graham also created a metric known as the Graham Number to measure a stock's fundamental value. （What Is the Graham Number? CAMERON WILLIAMS wrote in June 27, 2022, on www.thebalance.com）

The formula is:

Graham Number = the square root of [22.5 x (Earnings Per Share (EPS)) x (Book Value Per Share)]

For example, the Graham Number for a stock with an EPS of $1.50 and a book value of $10 per share would be $18.37.

Graham believed that a company's P/E ratio and price-to-book (P/B) ratio should not exceed 15x and 1.5x, respectively. This is where the coefficient 22.5 in the formula is derived from (15 x 1.5 = 22.5).

Once a stock's Graham Number is calculated and designed to represent its actual per-share intrinsic value, you can compare it to its current share price.

The stock is deemed undervalued and attractive if its share price is lower than the Graham Number.

If its share price exceeds the Graham Number, the stock is considered overvalued and not a good buy.

13 Pieces of Advice

1. Be an investor, not a speculator.

Investing is for value, whereas speculation is for price. Generally, investors can determine a company's value based on its assets and profit, but its share price is subject to market sentiment. So, it's vital to study a company's balance sheet and money-making ability if you take a value approach.

2. Buy a company of good value at a reasonable price.

Any commodity has a reasonable price, which is equal to its value. Rational investors are not likely to buy a product more expensive than its worth as they pursue the ideal of "buy cheap and sell dear". The difference between its value and market price is the margin of safety: the greater the margin, the less the risks.

3. Find the hidden value.

Value investing aims to find companies whose value is neglected by the market. Book value may show whether a company is undervalued or not. Book value refers to assets less liabilities (including both long-term and short-term debt) and less preferred dividends. Then, divide the book value by the number of common shares outstanding to calculate the intrinsic value per share. Compare the calculated result with the current share price. If it is higher than the market price, the company is very likely to have a hidden value, suggesting a good buy.

4. Determine the intrinsic value using another formula.

This formula involves EPS, the estimated growth rate in earnings, and the current yield on AAA-rated corporate bonds.

Intrinsic Value = EPS x (2 x Estimated Growth Rate in Earnings + 8.5) x 4.4 / Current Yield on AAA-Rated Corporate Bonds.

5. Stay prudent and be cautious about any rumors and data.

Before 1929, people had many fantasies about listed companies, but their hopes were dashed during the subsequent market crash. This experience made Graham skeptical about expectations, so he tended to value existing assets over earnings estimates.

6. Leave room for error.

Even a meticulous investor can make mistakes in measuring the intrinsic value. So, it's a good idea to maximize the margin of safety to lower risks.

7. Diversify the investment.

Investors may consider allocating at least 25% of their capital in both bonds and shares. For the remaining half, they can adjust the percentage of bonds or stocks based on specific circumstances.

8. Mathematics isn't everything.

Mathematics is just a tool. Investors should be cautious about security analysis based on calculus or advanced algebra.

9. Prioritize the business, not its share price.

For a stock investor, the first thing to look at before investing is the company itself instead of its current share price. A company is not necessarily expensive, though trading at a high price, if it can make a good profit, pay regular dividends to its shareholders, and have a healthy balance sheet. On the contrary, a company trading at a meager price is not a good buy if it is not making money, issuing dividends, or paying its creditors.

10. Dividends matter.

Companies that make regular dividend payments for 10-20 years are generally resistant to risks.

11. Value shareholders.

The management should prioritize the interests of their shareholders, which is also a criterion for investors when assessing the company's value. Shareholders need to bear in mind that they're entitled to defend themselves if the management infringes upon their rights and interests.

12. Be patient.

The primary difference between investing and speculating is the amount of risk undertaken. Utilizing patience to gather all relative market knowledge provides the groundwork to lower one's investment risk.

13. Think independently.

As opposed to speculators, investors need to be immune to the market sentiment and herd mentality. Independent thinking is one of the important steps in value investing.

The Bottom Line

Graham's theory of securities analysis, founded by his own efforts and wisdom, has influenced generations of investors, such as Warren Buffett, with his principles of investing safely and successfully.