Value Investing Strategy: Criteria for Picking Stocks

Value Investing Strategy: Investors appreciate and use the online stock trading techniques and strategies which are most useful for them. Over time, there has been a rise of many analysis tools & indicators, both fundamental and technical, to help traders. These analyzers help them identify spot opportunities, exit points, entry points, and other price levels. However, every tool has its pros and cons. But, probably the best long term strategy which has proved to be insanely accurate is – the Value Investing Strategy by Benjamin Graham.

In this article, we would try to understand it in simple terms and with the help of an example. This long-term approach technique has some suggested criteria too. We will also discuss the criterion points.

Value Investing – The Benjamin Method

One of the most successful investors of the 20th century, Benjamin Graham, developed a fantastic investment strategy. He named it Value investing because it emphasized much upon the actual value of a company while stock market trading. Here is the full history behind the development of this fantastic technique. 

According to this technique, an investor should try to spot and invest in the undervalued firms and then should wait for it to rise to its actual value. One can find any firm’s intrinsic or real value by doing some fundamental analysis. A trader after investing should wait for others to realize the worth of the company and then wait for it to get overvalued.

Benjamin Graham, also the father of the value investing, says that investors should individually decide the valuation criteria. However, he provided an essential criterion list to help traders too.

This value investing strategy is timeless and unbelievably accurate. 

Furthermore, Ben also discussed that there are two types of investors in this world – short term traders and long term traders. Short-term traders are predictors who play with the price fluctuations to earn a profit. And, long term investors should think of themselves as the owner of the organization. As a long term owner, you will not believe what other people think about your company. You know about its potential and prospects. However, you must have some facts and data to support your arguments.

At last, in simple words, invest in a profitably growing company which is trading lower than its intrinsic value today.

Example

As a trader, you want to invest, and you have two options. 

First ABC Ltd – a well-established and profitable organization in Europe; known for its telecom services…! It is the online stock trading at $250, and the earning per share is $20. 

Now, there is a small company too in the stock market trading as XYZ Ltd. It is a small-cap, telecom service partner. The stocks are trading at $40, and the earning per share is $6.

An investor following the bell’s strategy would first do the fundamental analysis first and then make a decision. After the examination, it was found that ABC Ltd. is over-priced because of the brand name and goodwill. And, the XYZ Ltd. outperformed it in every criterion.

Thus, investing his amount into the XYZ! 

Now, let’s quickly go through the criterion list suggested by Graham for choosing a company.

Criteria for Picking Stock Market Trading Shares 

Although Graham Bell didn’t force anyone to believe any criteria for judging the value of a company, he indeed suggested a ‘good criteria’ to help select one. But, he laid it upon the investor to evaluate and value an organization. There are 7 points in his criterion list:  

#1 Current Ratio: 

The current ratio is the ability of an organization to pay its current expenses. This ratio is dividing the existing assets by current liabilities. Benjamin took a ratio of 1.5 as the ideal one. It indicates the healthy financial condition of the company and can be directly found in a firm’s financial statement. 

#2 Price to Book Ratio: 

Price to book ratio is used by traders to identify the undervalued companies in terms of value. It is the value obtained after dividing the stock price by book value, per share. Book value is the value of a company left after clearing all the liabilities. Thus, an increment in book value is a positive sign, and because book value is in the denominator, in ratio, it would reduce the ratio.

Therefore, the lesser the ratio, the better it is. Ben suggested a ratio of less than 1.3, suitable for investing.

#3 Price to Earnings Ratio: 

The third criterion for value investing on our list is the P/E ratio. The low ratio is beneficial for an investor, and Graham considered anything less than 9.0 to be ideal for investing. The formula for calculating it is – divide the online stock trading share price by earning per share. It means how much the company is paying its shareholders as compared to its stock market trading value, i.e. stock price. The low P/E ratio company has good potential to grow and is probably under-valued.

#4 Ratings: 

The stock market trading exchange of any nation rates or ranks every listed company on its platform, based on quality. There are several deciding factors, and the rating is generally between A+ & D. However, you don’t need to pick the best A+ firms; anything above B is considered reasonable. The reason is to make sure the safety of your investment and not get fascinated by just good financial numbers. It also ensures the authentic existence as the exchange rates only 5-10-year-old organizations, depending upon the national exchanges. 

#5 Company’s Leverage: 

A company’s leverage means the amount of debt it has taken as compared to the current assets. Debt to EBITDA helps to determine the liability as compared to the earnings. A high ratio can mean that the company is taking too much borrowing to run its operation or buy assets. A high ratio is not a good sign, and anything below 1.10 should be considered acceptable.

#6 Earnings: 

Earning of the company should grow every year, and the percentage change should be significant. A growth of 33% is considered good and while investing, analyze the data for the last 8-10 years. Earnings denote the profitability per year and a decrease in it is not a good sign. Moreover, examine the cumulative growth for the previous 2-3 years to know the current rate of growth. It would help you be aware of high-risk companies. 

#7 Dividends: 

Dividend-paying market stock ensures that a company is earning and growing each year. The dividend record of a company should be decent enough and must not have any break in between. Also, it takes a little more time to get returns when you invest in an undervalued organization. So, the dividend will also get you some profit every year.

So, this was the criterion list of Sir Graham Bell’s value investing. This list is provided by him to make sure traders don’t fall for trapping companies, who show ‘Fake’ growth numbers and attract investors. 

 

The Bottom Line

In the Great Depression of 1929, Mr Bell lost most of his capital. Thus, it urged him to develop an anti-crash technique, which doesn’t get affected by the stock market trading downfall in the long term. The legend investor, Sir Warren Buffet, has been the student of Mr Graham and also follows his formula. And guess what! Now, you know Warren’s secret mantra too!

However, it is also essential to understand the components of the value investing strategy, which you can find here! And, you don’t even know how many people have created enormous profits from this technique. Why?

Simple, because it works on a fantastic principle of ‘money compounding’!!!

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