One of the students on my course was interested in the 11-rule Graham Value System and the method behind screening for stocks.
He asked a very good question, which was:
“why are certain values of financial ratios used? For instance, why do you look for a stock that has a PE between 5 and 20?”
The quick answer to this question is that the ratios used are those that have been shown to produce profitable and robust returns during historical back-testing. And I find that extreme values more often produce volatile and poor returns.
The slightly longer answer involves some understanding of how to interpret financial ratios so you can learn what they mean and how to use them effectively.
Instead of going through each financial ratio available (and there are many) I intend to focus only on the financial ratios that I have found to produce rewarding stock market returns and these are the ratios that are included in the 11-rule Value System.
How to interpret financial ratios: a quick guide to the 11 rules
# Market Cap
The first rule in the Graham Value System is a basic but important one concerning the market capitalisation of a company.
And market cap is just a way of expressing the total value of outstanding shares in a company. Market cap will therefore fluctuate as the share price of a company goes up and down.
In the instance of making profitable investments, market cap is fairly important since we do not want to buy shares in a company that is too small or too large.
Small companies are more volatile and go bankrupt much more often than larger companies and sometimes there may not be enough liquidity in their shares. This means that when we come to sell our investment, we may not be able to get a very good price for them.
Conversely, larger companies have the problem of being too big to add value.
A very large utility or financial company, for example, may be operating near it’s full potential. It’s ability to grow at more than 6% – 7% per year might therefore be questionable.
Historical back-tests showed that by including companies smaller than $100 million, returns went down and volatility went up. The 11-rule system therefore looks for companies with market caps greater than $100 million.
Even though larger companies may not be able to grow as fast, the system did not suffer by including them so no upper limit was set on market cap.
# P/E Ratio
Another rule in the Graham Value System is the P/E ratio which is one of the most popular methods for measuring the value of a stock by comparing the price of the security to it’s earnings.
If a company has a share price of $40 and reports earnings per share (EPS) of $4, it has a PE ratio of 10 ($40/$4).
Benjamin Graham may have been the first to show a link between PE ratios and stock returns and studies since then have also found that lower PE ratios typically point to stronger returns.
If you look through a large table of companies, you’ll find that most companies have PE ratios between 15 and 20. Therefore, a stock trading above the median PE level of 15-20 will be considered more expensive than a stock trading below the median PE level.
As well, the PE ratio can be used to indicate the type of growth that is currently expected for that company.
A PE ratio of 8.5 indicates a company with zero growth while a PE of 18.5 indicates growth of 5% per year. A PE of 48.5 indicates growth of 20% a year.
|Expected Growth Per Year||0||2.50%||5%||10%||20%|
Although, lower PE ratios are generally thought to produce higher stock returns, the value system found no reason for excluding stocks with PE ratios within the median range.
Companies with PE ratios below 5 are often cheap for a reason and companies with PE ratios above 20 are often too expensively priced to offer any margin of safety.
The value system found PE ratios between 5 and 20 to be the sweet spot.
# Lowest PE Over Last 12 Months
As value investors, the goal is to find stable, consistent performers that are solid in financial condition and undervalued in the market.
A stock that has seen it’s PE ratio fluctuate around the lower levels does not fit this picture and indicates that at one point in time the company was probably in trouble.
Such companies can be full of bumps in the road, which is why the Graham Value System ignores companies whose PE ratio had dropped below 5 at any point in the last 12 months.
# PEG Ratio
The PEG ratio is used in a similar vein to the PE ratio but in this instance the calculated PE ratio is compared with the expected growth rate for the company.
PEG Ratio = PE / Expected Growth Rate
The problem with the PEG ratio, then, is that different numbers can be used in place of the expected growth rate.
You can use the average or total expected growth rate over 1, 3, 5, even 10 years in the calculation and each one will yield a different answer.
(This is one of the reasons why financial ratios should be combined together. Using one ratio on it’s own is subject to much variability).
Financial commentators such as Peter Lynch found that lower PEG ratios led to better stock returns.
The Value System did not find the same significant relationship but found that PEG ratios less than 1 led to better returns. PEG ratios more than 3 or 4 generated poor returns.
# Price-to-sales Ratio
Price-to-sales is calculated by dividing the price per share (or market cap) by the revenue per share (or total revenue). It therefore indicates the balance between a company’s revenue and profit.
Some commentators suggest that investors should look for PS ratios no greater than 2. However, the problem with this, is that some companies (such as biotechs) may make very little money in the beginning despite having high sales.
When a company is not making a profit, the price-to-sales ratio can become meaningless. And, a very low price-to-sale ratio often shows up in some unbalanced, risky stocks.
The Graham Value System advocates a price-to-sales ratio that is greater than 0.5% with no upper limit.
# EPS Growth
When looking at stocks with a fundamental eye there is one underlying truth. That is, a stocks share price moves in relation to it’s earnings.
If a company is doing well, it’s earnings improve, and so does it’s share price. When a company does badly it’s earnings drop and it’s share price goes with it.
The problem for investors is trying to figure out not where the stock price will go, but where earnings will go and there are no easy ways to go about it.
The method put forward by value investors such as Benjamin Graham and Warren Buffett is to look for stable, long term records of earnings growth.
A company that has steadily grown earnings at a rate of 5% per year for the last 10 years is much easier to predict than a company that has grown earnings at a rate of 10% over just the last year.
The Value System looks for companies that have been able to grow earnings consistently over the last five years as these companies are the most likely to repeat those returns in the future.
# 1 Year Price Change
The 1 year price change rule is included in the Graham Value System as the only technical rule in the strategy.
The simple reason behind including this rule is that value investments often take a long time to play out.
There are many forces behind stock market moves and often the value investor cannot be privvy to the full information regarding a stock.
A good stock therefore, is one that has strong EPS growth combined with share price growth. By using a 1 year price change rule of greater than 8% the Value System avoids many undervalued stocks that are not going anywhere anytime soon.
# Dividend Yield
Companies that pay consistent dividends have been shown to produce more value to shareholders and there is a clear relationship between dividend yields and stock returns.
There is also a relationship between a company’s stock price (value of it’s outstanding shares) and it’s dividend yield so that when a stock falls in price, it’s dividend yield goes up. When a stock goes up in price, it’s dividend yield goes down.
Dividend yields less than 2% indicate that the stock price may be expensive when compared to the dividend payout.
On the other hand, dividends more than 7% may indicate something fundamentally wrong with the stock.
Often, a company with a very high dividend may have recently seen it’s share price fall, shortly after making a dividend payment. Thus the dividend yield appears high.
In reality, the company may be in difficulty and may need to scale back it’s next dividend payment. A dividend over 7% is considered too good to be true by McCarter and this was backed up by historical testing where big dividend yields did not translate into big returns.
# Net Margin
Another important ratio that is used in the 11-rule Graham Value System is net margin, also referred to as profit margin.
Put very simply, no company is able to survive for very long without turning a profit (though Amazon does try).
Net profit margin is therefore an important indicator as to how a company is performing, though it does not necessarily predict how that company will do in the future.
The other problem with net margin is that different analysts use different methods for calculating it. There is margin on profits, margin on revenue, profit after tax as well as profit before interest, taxes and amortization (EBITA).
Whichever method you use you should be consistent so you know how different profit margins compare against industries and companies.
Profit margins differ within industries and sectors so this needs to be taken into account when deciding between two securities.
The Value System looks for stocks with average net profit margins of at least 5% over the last 12 months and at least 3% over the last 5 years.
The advantage of this approach is that it tends to select companies that have maintained stable profit performance over different trading conditions.
More generally, stocks with higher profit margins should be preferred.
# Return On Equity (ROE)
Return on equity (ROE) is also referred to as the return on funds or capital employed.
Every business needs money to operate whether it is to pay it’s employees, order raw materials, or advertise the company, and a business usually gets that capital via shareholders, in the form of equity, or via lenders or banks, in the form of debt.
By calculating the return on the capital that is employed you can therefore compare an investment in the stock at hand with an investment in another asset, such as a government treasury bond.
If the return on equity (or capital employed) is no more than a government bond then there is very little point in going to the extra hassle and risk that comes with buying shares.
ROE is calculated from the various values for net margin, equity, and debt, and if it comes to less than 5% over the last 12 months it’s better to consider another investment.
More financial ratios to consider
The financial ratios discussed so far are the ones that make up the 11-rule Value System but it should be noted that there are other important ratios that you may want to consider.
As such, it may well be worth modifying the system for yourself and testing different combinations and values. This can be easily achieved using the simulator at Portfolio123.
Here are some additional financial ratios to keep in mind:
# Current Ratio
The financial ratios discussed so far mainly deal with finding growth, performance, and value.
However, there is another category to consider; that of financial condition and balance sheet strength.
The current ratio is calculated by dividing a company’s current assets by it’s current liabilities. It does a decent job of indicating financial strength whereby a score of more than 1 shows the company has enough cash in hand for it’s outgoings. Lower than 1 and the company is probably struggling.
Investors typically look for a current ratio greater than 1, 1.50, or even 2.
# Debt To Equity
In the same vein as the current ratio, the debt to equity is a good measure of financial strength that can be useful when looking for stable investments.
While not all debt is bad (most companies use several forms of debt to fund their operations), too much debt can result in heavy penalties from banks, if interest payments are not met on time.
Conversely, a company with no debt at all, might be missing out on some extra percentage points of growth.
There are different arguments regarding how much debt a company should undertake.
Once again, the best approach is to avoid the extremes and look for conservative values. McCarter suggests that the shareholders’ share should always exceed the banks’ share and it is sound advice.
As such, the debt to equity ratio should ideally be less than 1.
Don’t forget qualitative measures
The 11-rule Value System can be used on it’s own, in modified form, or as a base for making investment decisions.
Simply putting these values into a stock screener and buying the top 10 shares may return adequate results but in reality it is unlikely to produce staggering returns and you’ll often end up with more companies than your portfolio allows.
This is where your ability to choose between different companies will come into play and it’s important to use your gut and remember some of the more qualitative measures for success.
Qualitative factors such as:
Is the stock in a sector that is likely to grow over the next five years?
Does the company have a sound management team?
Do management own shares in the company?
Does the company have a history of growing dividends?
Does the trade conform to your overall world view on markets?
In the end, the financial ratios can lead you to some consistent, well performing companies with strong prospects.
Good returns can be made just with these. But choosing between them can make all the difference.
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