Benjamin Graham's 11 Rules for Appraisal of Common Stocks

Benjamin Graham, the father of value investing, has another set of rules for appraisal of common stock. Graham's teachings inspired a whole new generation of investors who went on to outperform the market over their long careers. Below is a set of 11 rules for the appraisal of common stock that Graham used in his class to teach his students, including Warren Buffett (Trades, Portfolio). These rules outline a simple way to appraise the value of a company's common stock.

Benjamin Graham's other set of rules for appraisal of common stock

1. Appraised value is determined by (a) estimating the earnings power, (b) applying the appropriate multiplier and (c) adjusting, if necessary, for asset value.
2. Earnings power should ordinarily represent an estimate of average earnings for the next five years.
3. Earnings power should ordinarily be derived from actual earnings over some period in the past. Where the trend has been neutral, the period should be five to seven years. Where definite trend is shown, actual earnings for the last year of reasonably normal general business may be taken, if it seems desirable.
4. In deriving earnings power, the past earnings may be adjusted for known or highly probable developments — e.g. changes in capitalization, properties, tax rates. Changes of a qualitative nature — e.g. in competitive conditions, products, management — should be reflected in the multiplier.
5. The multiplier should reflect prospective changes in earnings. A multiplier of 12 is suitable for stocks with neutral prospects. Increases or decreases from this figure must depend on the judgment and preference of the appraiser. However, in all but the most exceptional cases the maximum multiple should be 20 and minimum should be four.
6. If tangible asset value is less than earning power value (earning power X multiplier). the latter should be reduced by 20% of the deficiency to give the final appraised value. (Do not increase for excess tangible value except as under 7).
7. If net current asset value exceeds earnings power value, the latter should be increased by 50% of the excess to give the final appraised value.
8. Where extraordinary conditions prevail — e.g. war profits or war restrictions, temporary royalty or rental situation — the amount of the probable gain or loss per share due to such conditions should be estimated and added to or subtracted from appraised value as determined without considering the abnormal conditions.
9. Where the capitalization structure is highly speculative — i.e. the total of senior securities is disproportionately larger — than the value of the entire enterprise should first be determined as if it had common stock only. This value should be apportioned between the senior securities and the common stock on a basis that recognizes the going-concern value of the senior claims. (Note difference between this treatment and a valuation based on dissolution rights of the senior securities). If an adjustment is needed for extraordinary conditions, referred to in (8) this should be made in the total enterprise value, not on a per-share-of-common basis.
10. The more speculative the position of the common stock — for whatever reason — the less practical dependance can be accorded to the Appraised Value found.
11. When a stock’s appraisal is a third higher or lower than its current market value, that can be the basis for a decision to buy or sell. When the differential is less, the appraisal is merely another fact to consider in the analysis.