Benjamin Graham's PE Ratio Theory - Hints Towards A Bear Market?


Staff member
You must have observed that I frequently use the PE ratio for evaluating stocks.

Like many analysts today, I usually use the PE ratio for [SIZE=-1]±[/SIZE]3 years.

However, the father of "Value Investing" - Benjamin Graham, didn't exactly use the same approach.

(Today, Benjamin Graham's and David L. Dodd's "Security Analysis" is considered the bible of value investing.)

Graham emphasized using long term trend of earnings and not just rely on recent data, to evaluate stocks.

Most analysts use recent earnings to prove that US stocks are reasonably valued.

However, here is a nice article from the NY Times, which highlights how stock valuations in the US, look very different, when long term earnings are considered.

Today, the Graham-Dodd approach produces a very different picture from the one that Wall Street has been offering. Based on average profits over the last 10 years, the P/E ratio has been hovering around 27 recently. That’s higher than it has been at any other point over the last 130 years, save the great bubbles of the 1920s and the 1990s. The stock run-up of the 1990s was so big, in other words, that the market may still not have fully worked it off.
The argument that the writer uses is that fast profit growth may be possible for short periods, but it is not sustainable over long periods. Thus using longer periods of stock valuation seems more logical.
Alchemist, if time permits, could you explain Benjamin's formula in detail to help us evaluate stocks?

Consider buying the book "Intelligent Investor" by Benjamin Graham - it's a value buy.

All these points should be satisfied before picking a stock

1) Never buy small cap or mid cap. Only large caps
2) P/E shouldn't be greater the 100/(current quality bond rate).
i.e. for a high quality bond, if you get say 8% interest, then any stock you buy shouldn't
have a P/E greater than 100/8 = 12.5.
3) Point 2 can be relaxed slightly, if Price/Book Value is low.
P/BV * P/E shouldn't be greater than 25 (I think, or is it 22.5)
4) There should be a 30% increase in Earnings over a 10 year period (Earnings for both
end points should be calculated using a 3 year average).
5) The company should be paying a dividend continuously every year for 20 years (or 15, I forgot).

Other than that, keep a sharp eye for companies "cooking" the accounts like Enron - if
a recurring expenditure is treated as "Extraordinary Expense" in the annual support - something is fishy.

Avoid Serial Acquirers - i.e. avoid companies which keep buying other companies - if the
company themself puts their money in other companies, rather than their own company,
then why should you put your money in their company!!!!

A good company is not necessarily a good buy.
A good company is a good buy only if you get it cheap!!!

There is a lot more - but these are basic points.

By the way, Benjamin Graham doesn't believe in Technical Analysis.