Benjamin Graham was an economist and professional investor who taught Warren Buffett, Irving Kahn, Walter J. Schloss and other famous investors at Columbia Business School.
Buffett, who credits Graham with grounding him with a sound intellectual investment framework, describes him as the second most influential person in his life after his own father. In fact, Graham had such an overwhelming influence on his students that two of them, Buffett and Kahn, named their sons after him. In the preface to Graham's book, "The Intelligent Investor," Buffett calls it "by far the best book about investing ever written."
Graham recommended three different grades of stocks for investment, with specific calculations for identifying them. Today, we will do a complete Graham analysis on Facebook (NASDAQ:FB) and see what grade and price Graham would have recommended for it.
1. A Defensive Analysis:
The first grade of stocks recommended by Graham are called defensive stocks. The criteria that Graham specified for identifying defensive stocks are as follows:
Summarized from Chapter 14 of "The Intelligent Investor - Stock Selection for the Defensive Investor:"The publicly available financial figures for Facebook are as follows (sources here):
1. Not less than $100 million of annual sales.
[Note: This works out to $500 million today based on the difference in CPI/Inflation from 1973]
2-A. Current assets should be at least twice current liabilities.
2-B. Long-term debt should not exceed the net current assets.
3. Some earnings for the common stock in each of the past ten years.
4. Uninterrupted [dividend] payments for at least the past 20 years.
5. A minimum increase of at least one-third in per-share earnings in the past ten years.
6. Current price should not be more than 15 times average earnings.
7. Current price should not be more than 1-1⁄2 times the book value.
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.
|Annual sales||$3.71 billion|
|Current assets||$12.06 billion|
|Current liabilities||$899 million|
|Long term debt||$398 million|
|Shares outstanding||$2.74 billion|
Based on the above figures, we get the following results for each of Graham's defensive criteria:
Graham's recommended price for defensive stocks can be calculated from criteria No. 6 and No. 7 as the square root of (22.5 x EPS x BVPS). This price is popularly known as the Graham number and works out to $8.80 for Facebook. But this is not Graham's recommended price since Facebook doesn't meet the other defensive requirements.
Let's now take a look at the other grade calculations given by Graham and see if Facebook meets them.
2. An Enterprising Analysis:
If a stock failed to meet the criteria for defensive investment, Graham recommended the following criteria for enterprising investment.
Summarized from Chapter 15 of "The Intelligent Investor - Stock Selection for the Enterprising Investor:"This second set of criteria gives us a maximum price for a stock meeting enterprising conditions as - the lower of 120% net tangible assets (book value), or 10 times current earnings. Again, Facebook does not meet criteria No. 2, No. 3 and No. 4. If it had, the recommended price would have worked out to $5.20 per share.
[Note: For issues selling at P/E multipliers under 10]
1-A. Current assets at least 11⁄2 times current liabilities.
1-B. Debt not more than 110% of net current assets.
2. Earnings stability: No deficit in the last five years covered in the Stock Guide.
3. Dividend record: Some current dividend.
4. Earnings growth: Last year's earnings more than those of 1966.
[Note: This corresponds approximately to the earnings of 2007 today]
5. Price: Less than 120% net tangible assets.
Finally, let's look at the criteria that Graham recommended for NCAV, net-net or bargain stocks and see if Facebook meets them.
3. An NCAV or Net-Net Analysis:
If a stock met neither defensive nor enterprising requirements, Graham recommended these final set of criteria.
Summarized from Chapter 15 of "The Intelligent Investor - Stock Selection for the Enterprising Investor:"These criteria give us what are called NCAV stocks - stocks selling for less than the value of their cash worth alone, and with positive earnings in the last one year.
"Bargain Issues, or Net-Current-Asset Stocks"
"Price less than the applicable net current assets alone - after deducting all prior claims, and counting as zero the fixed and other assets."
"Eliminated those which had reported net losses in the last 12-month period."
These stocks are also the most famous of Graham's stocks, and the source of the general misconception that Graham recommended stocks only because they were cheap. These were, in fact, the last grade of stocks that Graham recommended.
Facebook's NCAV price works out to $3.93 and since the company has not reported net losses for the last 12 months, and since it does not meet any of the other sets of criteria, $3.93 is also Graham's recommended price for Facebook.
Facebook's IPO price of $38 works out to a P/E of 73 times last year's earnings, and a P/B of 5.8 times the book value. Facebook's current price of $19 works out to a P/E of 36.5 and a P/B of 2.87.
Since Facebook does not meet Graham's defensive or enterprising criteria but has not reported a net loss in the last one year, Graham's recommended price for Facebook is the NCAV price, which works out to $3.93. Even under ideal conditions, Graham's recommended price for Facebook would not have exceeded the Graham Number, which works out to $8.80.
See the comprehensive screener to see the above Defensive, Enterprising and NCAV calculations applied to each one of the 4000 companies listed on NYSE and NASDAQ.
Graham's elaborate financial calculations, when applied conscientiously to the financial data of companies, highlight any discrepancies between stock prices and the underlying numbers. Having such information helps in making objective investment decisions, minimizing losses and identifying unique investment opportunities.