Benjamin Graham
“An investment operation is one which, upon thorough analysis, promises safety of principal
and an adequate return. Operations not meeting these requirements are speculative.”
and an adequate return. Operations not meeting these requirements are speculative.”
Benjamin Graham  (1894 – 1976) Britishborn American economist and professional investor.
Ben Graham is widely acknowledged as the Father of value investing having developed the art of fundamental analysis in the early part of the last century. Between 19361956 Graham’s firm returned a CAGR of 21%.
Graham's Core Concepts
The system of value investing is built upon two fundamental concepts, namely 'Intrinsic Value' and 'Margin of Safety'.
Intrinsic Value  Graham determined that every security has an inherent value, this could be the liquidation value of assets if they were sold, or the earnings power of those assets if they were utilized to create a product or service. Graham argued that the intrinsic value of a security was not an immutable equivalent of its market price. He further posited that a security's market price would fluctuate around its intrinsic value, sometimes moving below it, other times moving above it and occasionally meeting at a point of parity with it. Based upon this line of reasoning Graham argued that one could profit from the disconnect between a security's intrinsic value and its market price by buying a security when it was undervalued and selling it when it was at or above its intrinsic value. In order to determine a security's intrinsic value Graham developed the method of fundamental analysis whereby an investor would study the accounts of a given company to determine the value of its assets and the earnings power of those assets.
Margin of Safety  Graham was a logical thinker who was well aware of the risks associated with investing, for this reason he argued that investors should employ what he called a 'margin of safety' when investing in order to account for those risks. After a given security's intrinsic value was established Graham recommended that investors should aim to buy it at a discount in order to account for risks and analytical errors. Whist there is no concrete figure which should be applied as a margin of safety there are some simple points to consider.
Ben Graham is widely acknowledged as the Father of value investing having developed the art of fundamental analysis in the early part of the last century. Between 19361956 Graham’s firm returned a CAGR of 21%.
Graham's Core Concepts
The system of value investing is built upon two fundamental concepts, namely 'Intrinsic Value' and 'Margin of Safety'.
Intrinsic Value  Graham determined that every security has an inherent value, this could be the liquidation value of assets if they were sold, or the earnings power of those assets if they were utilized to create a product or service. Graham argued that the intrinsic value of a security was not an immutable equivalent of its market price. He further posited that a security's market price would fluctuate around its intrinsic value, sometimes moving below it, other times moving above it and occasionally meeting at a point of parity with it. Based upon this line of reasoning Graham argued that one could profit from the disconnect between a security's intrinsic value and its market price by buying a security when it was undervalued and selling it when it was at or above its intrinsic value. In order to determine a security's intrinsic value Graham developed the method of fundamental analysis whereby an investor would study the accounts of a given company to determine the value of its assets and the earnings power of those assets.
Margin of Safety  Graham was a logical thinker who was well aware of the risks associated with investing, for this reason he argued that investors should employ what he called a 'margin of safety' when investing in order to account for those risks. After a given security's intrinsic value was established Graham recommended that investors should aim to buy it at a discount in order to account for risks and analytical errors. Whist there is no concrete figure which should be applied as a margin of safety there are some simple points to consider.
 The higher the risk associated with the security in question, the greater the margin of safety which should be applied.
 The lower the level of conviction an investor has of their investment thesis, the higher the margin of safety which should be applied.
Graham's investing formula
Throughout his career Graham employed a number of different variations of the value investing system and developed several different methods for calculating intrinsic value. Below is a summary of these methods.
Netnet Investing (Based upon the liqudation value of a company's assets)
Below is a summary of the method Graham employed to value a company's assets. It should be noted that this approach was intially developed after the great depression when a large part of the market consisted of industrial companies possessing tangible assets. Markets today are obviously quite different with many more companies possessing intangible assets and so this must be taken into account. Further, there tends to be a greater abundance of stocks selling below liquidation value when the market is severely depressed and the pool of prospective investments will expand or contract according to the current state of the market. The term 'Netnet' is used as the final value arrived at is net of both Total liabilities and Fixed assets.
Net Current Asset Value (NCAV) = Current assets  Total liabilities & Prior claims
Below is a summary of the method Graham employed to value a company's assets. It should be noted that this approach was intially developed after the great depression when a large part of the market consisted of industrial companies possessing tangible assets. Markets today are obviously quite different with many more companies possessing intangible assets and so this must be taken into account. Further, there tends to be a greater abundance of stocks selling below liquidation value when the market is severely depressed and the pool of prospective investments will expand or contract according to the current state of the market. The term 'Netnet' is used as the final value arrived at is net of both Total liabilities and Fixed assets.
Net Current Asset Value (NCAV) = Current assets  Total liabilities & Prior claims
Netnet Working Capital (NNWC)
= Cash & Equivalents + (0.5 x Inventories) + (0.75 x Receivables)  Total liabilities & Prior claims
Net Cash = Cash & Equivalents  Total liabilities & Prior claims
Graham usually insisted on buying a Netnet stock only when it traded at <67% of it's fair value but at certain times in his career he increased this to <50%. When employing the Netnet approach one should buy a basket of stocks to mitigate
nonmarket risks associated with individual companies.
"Statistics say that owning just two stocks eliminates 46% of the non market risk of owning just one stock. This type of risk is supposedly reduced by 72% with a fourstock portfolio, by 81% with eight stocks, 93% with 16 stocks, 96% with 32 stocks, and 99% with 500 stocks."  Joel Greenblatt; 'You Can Be a Stock Market Genius'
Graham recommended a portfolio of 30 stocks to mitigate nonmarket risk. Expanding the number of stocks in the portfolio any further will do little to meaningfully lower nonmarket risk and will begin to negatively impact total returns. Enterprising investors seeking to further boost investment returns could opt for a portfolio of 1020 stocks but must be aware that this will likely result in an increase in volatility and a higher exposure to nonmarket risk.
Backtesting Graham's Netnet Strategy
There have been numerous backtest studies conducted across various countries and time periods based upon Graham's Netnet strategy and all have shown a significant outperformance relative to the market.
Professor of finance, Henry Oppenheimer, of the State University of New York backtested the Netnet criteria over a 13year period between 31 December 1970 to 31 December 1983. Oppenheimer only selected stocks selling <67% NCAV and assumed that all stocks were purchased on December 31st, were held for a year, and then the portfolio rebalanced. The total number of stocks in the study amounted to 645 with a largest and smallest annual sample of 89 and 18 repsectively.
Average annualized returns for the 13year period were 29.4% vs 11.5% for the NYSEAMEX index. In dollar terms $10,000 invested in the NCAV approach would have compounded to $285,197. The same $10,000 would have only grown to $41,169 had it been invested in the NYSEAMEX index.
There have been numerous backtest studies conducted across various countries and time periods based upon Graham's Netnet strategy and all have shown a significant outperformance relative to the market.
Professor of finance, Henry Oppenheimer, of the State University of New York backtested the Netnet criteria over a 13year period between 31 December 1970 to 31 December 1983. Oppenheimer only selected stocks selling <67% NCAV and assumed that all stocks were purchased on December 31st, were held for a year, and then the portfolio rebalanced. The total number of stocks in the study amounted to 645 with a largest and smallest annual sample of 89 and 18 repsectively.
Average annualized returns for the 13year period were 29.4% vs 11.5% for the NYSEAMEX index. In dollar terms $10,000 invested in the NCAV approach would have compounded to $285,197. The same $10,000 would have only grown to $41,169 had it been invested in the NYSEAMEX index.
Original Graham formula
IV = EPS x (8.5 + 2G) IV : Intrinsic value EPS: (ttm) Earnings per share G : Earnings growth rate 
The original Graham formula is taken from 'Security Analysis' and determined the intrinsic vaue of a stock by taking the trailing twelve months earnings per share of a company, then multiplying it by 8.5 (the average P/E ratio of a stock with 0% growth) + 2x the 710 year historical earnings growth rate. The Graham formula should be considered to occupy the upper boundary of intrinsic value range and adjustments to should be made to EPS figures to account for cyclical fluctuations and nonrecurring items.

Modified Graham Formula
IV = EPS x (8.5 + 2G) x 4.4 / Y IV : Intrinsic value EPS : (ttm) Earnings per share G : Growth rate Y : AAA Corporate bond rate 
Ben Graham later modified his orginal formula to include a required rate of return, this is the number 4.4 in this equation. At the time of the formula's publication in the early 1960's this was the risk free interest rate. In order to adjust to the present one divides the resulting figure by the current AAA corporate bond rate.

Graham number formula
IV = √ (22.5 x EPS x BVPS) IV : Intrinsic value EPS : Earnings per share BVPS : Book value per share 
Benjamin Graham developed this formula to ensure he didn't pay more than 15x Earnings and 1.5x Book value for a stock, thus the number 22.5 in this formula is 15 x 1.5. This fomula will only work for companies with both earnings and book value which are positive. EPS should be normalized for cyclicals and companies with recent nonrecurring items. Growth is not factored into this equation and so it is not suitable for young fast growing companies. If tangible book value is being used the formula will not capture the value of intangible assets such as brand names, trade marks, patents, proprietary software etc.

Graham's Simple Stock Selection Criteria
In a March 6th, 1976 interview for the Financial Analysts Society Ben Graham discusses the evolution in his thinking with regards to investing. This was based upon statistical research which he had recently conducted "...I have lost most of the interest I had in the details of security analysis which I devoted myself to so strenuously for so many years, I fell that they are relatively unimportant, which, in a sense, has put me opposed to developments in the whole profession. I think we can do it successfully with a few techniques and simple principles'"
Below is Graham's 10 point Simple Stock Selection Criteria
This was later refined to an even simpler set of criteria dubbed 'Graham's Simple Way Investing Strategy'.
In a March 6th, 1976 interview for the Financial Analysts Society Ben Graham discusses the evolution in his thinking with regards to investing. This was based upon statistical research which he had recently conducted "...I have lost most of the interest I had in the details of security analysis which I devoted myself to so strenuously for so many years, I fell that they are relatively unimportant, which, in a sense, has put me opposed to developments in the whole profession. I think we can do it successfully with a few techniques and simple principles'"
Below is Graham's 10 point Simple Stock Selection Criteria
 An earnings yield (reverse of the P/E ratio) that is double the tripleA bond yield.
 A P/E ratio that is 4/10 of the highest average P/E ratio achieved by the stock in the most recent five years.
 A dividend yield of 2/3 the tripleA bond yield (Stocks paying no dividends are excluded from the list).
 A stock price of 2/3 the tangible book value per share.
 A stock price that is 2/3 of the net current asset value or the net quick liquidation value.
 Total debt that is less than tangible book value.
 A current ratio of >2
 Total debt at or less than the net quick liquidation value.
 Earnings that have doubled in the most recent ten years.
 No more than two declines in earnings of >5% in the past ten years
This was later refined to an even simpler set of criteria dubbed 'Graham's Simple Way Investing Strategy'.
 Buy stocks that have an earnings yield twice the AAA bond yield or more.
 Never buy stocks for more than 10x earnings; a PE of 7x is always allowed.
 Make sure each stock has an equity to assets ratio of 50% of more.
Backtesting Graham's Simple Stock Selection Criteria
Professor of finance, Henry Oppenheimer, of the State University of New York backtested the criteria from the period 19741981.
"By using Graham's criteria (1) and (6) to select securities from the combined NYSEAMEX universe, an investor could have achieved a mean annual return of 38 percent!
Use of criteria (3) and (6), [or] (1), (3) and (6) would have resulted in mean annual returns of 26 percent and 29 percent respectively.
Although the superior performance...declined after 1976, it did not disappear. Futhermore, the performance does not appear to be due either to systematic risk or to size effects."  Henry R. Oppenheimer, "A Test of Ben Graham's Stock Selection Criteria", Financial Analysts Journal (September/October, 1984) : pg, 70, 71 and 72.
Professor of finance, Henry Oppenheimer, of the State University of New York backtested the criteria from the period 19741981.
"By using Graham's criteria (1) and (6) to select securities from the combined NYSEAMEX universe, an investor could have achieved a mean annual return of 38 percent!
Use of criteria (3) and (6), [or] (1), (3) and (6) would have resulted in mean annual returns of 26 percent and 29 percent respectively.
Although the superior performance...declined after 1976, it did not disappear. Futhermore, the performance does not appear to be due either to systematic risk or to size effects."  Henry R. Oppenheimer, "A Test of Ben Graham's Stock Selection Criteria", Financial Analysts Journal (September/October, 1984) : pg, 70, 71 and 72.
Ben Graham also developed a simple set of rules for managing a portfolio. they are as follows;
Graham's Simple Portfolio Strategy
Graham's Simple Portfolio Strategy
 Maintain a well diversified portfolio of >30 stocks.
 Sell a stock after a 50% rise in price.
 If a stock hasn't met your objective within 2 years of purchase, sell it regardless of price.