Thursday, March 8, 2012

Fundamental Analysis – Graham–Rao Method


Graham Method for Conservative Investors

Benjamin Graham[1] is credited with systematizing fundamental analysis.

In his books, he outlined methods that could be used by conservative investors for buy and hold investments as well as methods that could be used by active traders.

One comprehensive method recommended for use by conservative investors is as follows:


1. Adequate Size of the Enterprise

Our idea is to exclude small companies which may be subject to more than average vicissitudes especially in the industrial field. The size is specified as not less than $100 million of annual sales for an industrial company and, not less than $50 million of total assets for a public utility.

2. A Sufficiently Strong Financial Condition

For industrial companies current assets should be at least twice current liabilities—a so-called two-to-one current ratio. Also, long-term debt should not exceed the net current assets (or “working capital”). For public utilities the debt should not exceed twice the stock equity (at book value).

3. Earnings Stability

Some earnings for the common stock in each of the past ten years.

4. Dividend Record

Uninterrupted payments for at least the past 20 years.

5. Earnings Growth

A minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end.

6. Moderate Price/Earnings Ratio

The investor should impose some limit on the price he will pay for an issue in relation to its average earnings over, say, the past seven years. We suggest that this limit be set at 20 times such average earnings


7. Moderate Ratio of Price to Assets

Current price should not be more than 1.5 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5. (This figure corresponds to 15 times earnings and 1.5 times book value)  


This method is a useful method of investment analysis. But I could not locate practical application of this method in published magazines. In my efforts to operationalize this method for Indian stocks, I came out with some modifications that make the method clear and ready for implementation based on past financial data. The modified criteria are[2]:

 Narayana Rao, K.V.S.S., "In search of value", Business Standard-Smart Investor, 8 January 2007.

Security Analysis Article Directory
http://knol.google.com/k/narayana-rao-kvss/-/2utb2lsm2k7a/140




Applications of the Method
2009 based on 2008 results


I T C Ltd.
Graham-Rao Analysis: Reliance Industries Limited.
State Bank Of India
Wipro Ltd.

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hits counter Original post in Knol
http://knol.google.com/ k/ fundamental-analysis-graham-rao-method, Knol Number 7

 

A Poem on the Method

I wrote a poem on the method

Fundamental Analysis
The company's life is long
But its loans are small
It makes profits
and shares with partners
Its profits grow
Its assets grow
Its reputation grows
Its liquidity grows
You can calculate its value
and there is a seller who concurs with your view.
For more poems on stock market topics visit Stock Market Poems

 

Related Articles


 Graham-Rao Method

(Customized to India)
The company must have an adequate size (Rs 100 crore sales may be taken as adequate size for Indian companies) and a strong financial condition.

To satisfy this criterion, the current assets should be at least twice that of current liabilities and the total debt-equity ratio should not be greater than 1:1.

The company should have paid dividends and earned profits for the last 10 years. There should be a growth in earnings per share (EPS) of 10 per cent per annum over the last seven years.

The current price should not exceed 20 times the average EPS in the last seven years for companies with past seven-year growth higher than 20 per cent. For companies with past growth rates between 10 and 20 percent per annum, the multiplier has to be the growth rate itself.

The current price should also not be more than 1.5 times the book value last reported.

These prescriptions by Graham require 10-year data to pick stocks. But the method is unambiguous and uses a limited number of ratios.

Investors have to keep in mind that their hard-earned money has to be protected by committing it to companies with a good past record.
 
The method was explained to students as well as investors and they agreed that it was unambiguous. I present this method in all courses that I teach on Security Analysis.
The method was applied twice by me across all the stocks for which data was available on the electronic database and the companies suitable for investment were identified. The article "In Search of Value" published in Business Standard, 8 January  2007, contains the selected scrips using the method at that time. 


Benjamin Graham, Intelligent Investor, various editions, Latest edition, Harper Business Essentials,

Narayana Rao, K.V.S.S., A nine-step route to picking value stocks”, Business Standard-Smart Investor, August 25, 2003
Narayana Rao, K.V.S.S.,"The merit of value investing",  Business Standard-Smart Investor,
November 27, 2006



http://business-standard.com/india/storypage.php?autono=265971

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