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How to Do a Buffett-Graham Inspired Stock Analysis

February 26, 2012 | Comments: 0 | Views: 178

I'd like to first reference a quote from 'The Intelligent Investor' by Ben Graham which sums up what your job should be when analyzing any security, in our case, common stocks.

"The security analyst deals with the past, the present and the future of any given security issue. He describes the business; he summarizes its operating results and financial position; he sets forth its strong and weak points, its possibilities and risks; he estimates its future earning power under various assumptions, or as a "best guess." He makes elaborate comparisons of various companies or of the same company at various times. Finally, he expresses an opinion as to its attractiveness as a purchase, if it is a common stock."

In general, these are the activities investors should diligently perform when analyzing a stock for possible purchase. To expand on these simple ideas, we will elaborate on how to accomplish the activities of a security analyst, keeping in mind the timeless framework of a Ben Graham/ Warren Buffett type of analysis.

Are you a Defensive or Enterprising Investor?

Being aware of your own personal style and tolerance for volatility, a Buffet/ Graham inspired investor must choose between being a defensive investor or an enterprising investor. As a defensive investor, Graham recommends sticking to larger companies that have a long term record (20+ years) of dividend increases. A long term record of dividend increases, he explains, is a reliable measure of the quality of the issue. On the other hand, an enterprising investor is free to look for smaller, underappreciated stocks trading at less than 'net current assets (or working capital)' and/or issues that have a favourable 'return on invested capital (ROIC),' terms we will go into more detail later.

Common Stock Criteria

A strict Graham style philosophy should adhere to these specific criterions. In more recent times, Buffett has ventured outside of the guidelines, becoming more willing to pay a higher price for a company with 'intrinsic value.' Despite that, the Buffet/Graham inspired investor should adhere strictly to the guidelines of financial condition and earnings stability outlined below. These are commonalities that all great investments usually have.

1. Earnings Multiplier - An earnings multiplier, or p/e ratio, of below 10.2. Financial Condition - a) Current assets at least 1.5 times current liabilities, and b) debt no more than 110% of net current assets. (A measure I like to use for debt is, long term debt/ shareholders equity should equal less than 0.5)3. Earnings Stability - Has not lost money in the last 5 years.4. Earnings Growth - Last year's earnings more than that of the year before.5. Price - Less than 120% of net tangible assets.

A Closer Look at Net Current Assets, Net-Working Capital and ROIC (Return on Invested Capital)

Very simply, net current assets and net-working capital can be used interchangeably (they are the same thing). To arrive at the net-working capital, you take the per share value of current assets minus the per share value of total liabilities, divided by the number of shares outstanding. If this number is higher than the price of the stock, the issue is trading at a discount to net current assets or net-working capital, which would symbolize a great value in Grahams mind. Graham has long been a proponent of buying stocks trading below their net-working capital. Stocks trading below net current assets are almost impossible to find in a bull market. Be on the lookout during recessions for these super cheap deals, they tend to bounce back once the market recovers.

ROIC is closely related to earnings per share, yet is a more pure way of gauging the earnings power of a company. The key benefit of ROIC over EPS is it disregards accounting and one time charges that can distort EPS estimates.

ROIC = Owner Earnings / Invested Capital

Where owner earnings equals operating profit...- plus depreciation and amortization - minus income tax, cost of stock options, capital expenditures and any income generated from unsustainable returns from pension funds.

And where Invested Capital equals total assets...- minus cash, short term investments and non-interest bearing current liabilities- plus past accounting charges that reduced invested capital

An ROIC of at least 10% is attractive; even an issue with 6-7% ROIC can be somewhat attractive if the company has great brands and competent management.

Arriving At Your Margin of Safety

Stocks that adhere to most of the above criteria can substantially increase your margin of safety, which decreases your chance of losses (a big part of Graham philosophy). Mr. Buffett's approach has combined Graham's margin of safety with an emphasis on future growth and detachment from market behaviour and benchmarks. Buffett relies less on quantitative analysis and prefers to think in more simplistic terms to arrive at his investment decisions. Buffett's philosophy focuses on easily understandable businesses, in excellent financial health, that have a fantastic record of uninterrupted increases in ROIC. Both philosophies emphasize management of high integrity that think like owners rather than managers and do not pay themselves lavish salaries.

Using a Buffett/Graham inspired analysis, an investor can learn to understand how to value a stock and therefore compare issues to each other to come to a more favourable investment decision. A point to emphasize in investing is the willingness to say 'no' and turn down investment opportunities that do not follow certain criteria. Buffett and his partner Charlie Munger have spoken of this publicly several times. Basically, they say over a lifetime, you may come across no more than 20 life changing investment opportunities. The objective of an investor should be to firstly, recognize these opportunities and secondly, take advantage of them by acting boldly and investing heavily in them.

John Laframboise is founder and author at http://www.riseofamillionaire.com, a personal finance Blog that follows his progress to become a millionaire. John has held positions within the Canadian banking industry and has a Bachelor of Commerce from the University of Windsor in Canada.

Source: EzineArticles
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