Value investing is all about identifying and investing in undervalued stocks rather than investing in market winners. Value stocks are the stocks that are trading at a lower rate in comparison to their fundamentals or intrinsic value. The strategy of value investing pays more focus on company fundamentals rather than the stock price of the company.

Benjamin Graham, considered as the godfather of value investing, lays down various strategies to identify value stocks clearly in his book, ‘The Intelligent Investor’. The book is considered as ‘by far the best book on investing ever written’ by Warren Buffet himself. Graham’s value investing principles are time-tested and undeniably accurate. Let’s understand these seven timeless principles mentioned by Benjamin Graham for selecting value stocks.

1. Quality ranking

In his book, ‘The Intelligent Investor’, Benjamin Graham recommended issues that are ranked average or better in quality by Standard & Poor (S&P). ‘Earning & Dividend Quality Rank’ assigned to companies by Standard & Poor (S&P Global) is based on various factors related to growth and stability for over the past 10 years. The S&P ranking can vary from C to A+. However, it is advised to select the stock that has S&P ranking B+ (average) and better to ensure safety. Basically the book suggests looking for a company that has satisfactory past records in terms of growth and stability, but not fascinating to the public.

2. Financial leverage

Picking the company with a strong financial position is important in value investing. Company’s financial leverage denoted by debt to total asset ratio is an important consideration while picking value stocks. Benjamin Graham advice in his book to select companies with debt not more than 110% of net current assets (for industrial companies). Companies with higher financial leverage are incurring excessive debt to finance its assets. Hence, selecting companies with relatively low debt are the better consideration.

3. Company’s liquidity

Company’s ability to pay denoted by the current ratio (comparison of current assets to liabilities) is an important consideration in value investing. Benjamin Graham advises selecting the company with current assets at least 1 ½ times its current liabilities. The ratio indicates the company’s ability to pay short-term liabilities.

4. Price to earnings ratio

Price to earnings ratio is important in value investing as the market value of the stock can be determined by comparing to the company’s earnings. With the P/E ratio of the stock, you can understand how much the market is willing to pay for the particular stock based on past and future earnings. Benjamin Graham advises picking the stock with a low to moderate price to earnings ratio. If the stock has a low P/E ratio to peer stocks within the industry or sector, the stock is possibly undervalued. When the stock is relatively low in comparison to earnings, it has the potential to grow.

5. Earnings growth

Percentage change in earnings per share over the period is a crucial consideration for value investing. Benjamin Graham advises selecting stocks with positive earnings per share growth at least by one third. As per his suggestion, cumulative growth for the last few years needs to be considered while selecting the stock. Earnings per share (EPS) indicates the company’s profitability. And earnings per share growth indicates the rate at which the company has grown its profitability.

6. Price to book ratio

Price to book ratio is an important tool that indicates whether the stock is overvalued or undervalued by comparing the company’s current market price to its book value. Benjamin Graham recommends price to book value ratio of not more than 1.5. If the price to book ratio is close low to moderate, which means the price of the stock is not overvalued.

7. Dividend record

Dividend record of the company is crucial. Benjamin Graham recommends investing in companies that are currently paying dividends. As dividends are a form of cash flow while you wait for the undervalued stock to perform. Value investing is a long term process as you wait to reach the desired level can take longer. The consistent payment of dividend also indicates the quality of the company and the earnings it is generating.

Thus, value investing is identifying the undervalued stocks that have huge potential to grow and provide capital gain over the long run. Benjamin Graham also stresses on “Margin of safety”—never overpaying, no matter how exciting an investment seems to be in order to minimize your odds of error. Benjamin Graham’s principles lay the foundation for you to select value stocks based on an in-depth study of company fundamentals.

While picking a value stock, it’s also important to understand the business thoroughly such as knowing reasons as to why the stock is undervalued, expected time span of the problem, if any and what growth plans are in place by the management etc. Graham’s greatest student, Warren Buffet, says, ‘’Never invest in a business you cannot understand’’. Hence, understanding the business is the key. Let your investment approach be disciplined and consistent. Long-term value investing needs you to have patience and confidence.

Even with the change in time and market, Benjamin Graham’s advice still holds true and is accurate for investors who are aiming to create wealth over the long run by investing in value stocks. All you need to do once you pick the right stock is, let your patience, discipline and confidence to rule your financial destiny.

(By Harsh Jain, Co-founder and COO, Groww)