The Intelligent Investor

by Benjamin Graham

The most basic possible definition of a good business is this: It generates more cash than it consumes.

To fine-tune the definition of owner earnings, you should also subtract from reported net income:

any costs of granting stock options, which divert earnings away from existing shareholders into the hands of new inside owners any “unusual,” “nonrecurring,” or “extraordinary” charges any “income” from the company’s pension fund.

owner earnings per share have grown at a steady average of at least 6% or 7% over the past 10 years, the company is a stable generator of cash...

Next, look at the company’s capital structure. Turn to the balance sheet to see how much debt (including preferred stock) the company has; in general, long-ter...

The burden of proof is on the company to show that you are better off if it does not pay a dividend. If the firm has consistently outperformed the competition in good markets and bad, the managers are clearly putting the cash to optimal use.

Two shares of a stock at $50 are not worth more than one share at $100.

Companies should buy back their shares when they are cheap—not when they are at or near record highs.

In investing, as with life in general, ultimate victory usually goes to the doers, not to the talkers.

As an intelligent investor, the only thing you should do with pro forma earnings is ignore them.

Graham’s criterion of financial strength still works: If you build a diversified basket of stocks whose current assets are at least double their current liabilities, and whose long-term debt does not exceed working capital, you should end up with a group of conservatively financed companies with plenty of staying power.

The best values today are often found in the stocks that were once hot and have since gone cold.

Dividend record.

Earnings growth. How many companies in the S & P 500 increased their earnings per share by “at least one third,” as Graham requires, over the 10 years ending in 2002? (We’ll average each company’s earnings from 1991 through 1993, and then determine whether the average earnings from 2000 through 2002 were at least 33% higher.) According to Morgan Stanley, 264 companies in the S & P 500 met that test. But here, it seems, Graham set a very low hurdle; 33% cumulative growth over a decade is less than a 3% average annual increase. Cumulative growth in earnings per share of at least 50%—or a 4% average annual rise—is a bit less conservative. No fewer than 245 companies in the S & P 500 index met that criterion as of early 2003, leaving the defensive investor an ample list to choose from.

Graham recommends limiting yourself to stocks whose current price is no more than 15 times average earnings over the past three years.

Instead, calculate a stock’s price/earnings ratio yourself, using Graham’s formula of current price divided by average earnings over the past three years.3

Moderate price-to-book ratio. Graham recommends a “ratio of price to assets” (or price-to-book-value ratio) of no more than 1.5. In recent years,

multiply the P/E ratio by the price-to-book ratio and see whether the resulting number is below 22.5?

Do your homework. Through the EDGAR database at www.sec.

tell you what percentage of a company’s shares are owned by institutions. Anything over 60% suggests that a stock is scarcely undiscovered and probably “overowned.” (When big institutions sell, they tend to move in lockstep, with disastrous results for the stock.

He suggested starting off by spending a year tracking and picking stocks (but not with real money).

but limit it to a maximum of 10% of your overall portfolio (keep the rest in an index fund).

Robert Torray of the Torray Fund all suggest looking at the daily list of new 52-week lows in the Wall Street Journal or the similar table in the “Market Week” section of Barron’s.

That will point you toward stocks and industries that are unfashionable or unloved and that thus offer the potential for high returns once perceptions change.

ROIC of at least 10% is attractive; even 6% or 7% can be tempting if the company has good brand names, focused management, or is under a temporary cloud.

Factiva, ProQuest, or LexisNexis

By separately analyzing each of the company’s divisions this way, you may be able to see whether they are worth more than the current stock price. Longleaf’s Hawkins likes to find what he calls “60-cent dollars,” or companies whose stock is trading at 60% or less of the value at which he appraises the businesses. That helps provide the margin of safety that Graham insists on.