Methods

We believe that all of our methods are based on Benjamin Graham’s basic strategy and teachings. We have studied The Intelligent Investor and Security Analysis, and understand his approach. We believe in no other way of investing – any method that is not based on value investing is merely speculating.

After reading Graham’s writings, we spent time studying Warren Buffett’s modifications and style. We believe that Buffett follows Graham’s teachings extremely well and that is the reason he has been so successful. Buffett’s greatest contribution to value investing are his guidelines for the selection of companies with good management.

Overall, Graham taught us the philosophy behind valuing a company and investing, while Buffett has shown an example of how to apply Graham’s knowledge and has taught us how to be more critical of management.

We have developed this website and our own methods in an effort to modernize Graham’s teachings, and we have updated many of his basic requirements of companies. For example, Graham suggested that defensive investors shy away from companies with less than $100 million in annual sales. We update that by requiring a market cap of $2 billion for the defensive investor.

Additionally, we use a number of different approaches to traditional terminology. Here is a short explanation of some of our terminology:

Intrinsic Value – In The Intelligent Investor, Benjamin Graham presents a formula as follows:  Intrinsic Value = EPS x (8.5 + 2g).  After studying this model we found that it does provide a solid foundation for determining value.  In modernizing the formula, we changed the EPS used to our normalized EPSmg.  We also looked at the 8.5 factor and determined in this post that if you are looking at a no growth company (thus making the formula be EPS x 8.5), you are left with a perpetuity of the current earnings level.  Therefore, the 8.5 comes from the valuation of a perpetuity (V = earnings / discount factor) with a discount factor of 11.76%, which is near the long-term average return on equities.  We also have a calculator page where you can run the formula.

EPSmg – Graham taught us to normalize the earnings in order to determine what level of earnings can be expected in the future.  As a result, instead of using the current EPS, we use a 5 year weighted average of the diluted EPS to determine a the EPSmg level.  The weights are based on a sum of the years digits method (often used for depreciation) with emphasis on the most current annual periods.

Estimates – We make a very conservative estimate when determining what the future earnings may be.  Earnings estimates are often wrong and we limit our forecasts to a maximum of three quarters.  Specifically, if the first quarter actual earnings are not available at the time of valuation, we do not make any estimate on the next fiscal year.  If the first quarter actuals are available, we will use the lowest published analyst estimate for the remaining quarters in the company’s fiscal year.  If the first and second quarter actuals are available, we add those to the lowest published estimates for the third and fourth quarters to determine our fiscal year estimate.  If the third quarter actuals are available, we add the lowest published estimate for the fourth quarter to the actuals produced in the three quarters to date.

Growth – Our estimate for growth is based on taking the growth in EPSmg from the current period (or estimate) less the EPSmg from five years prior.  The average over the period is then taken, subject to a safety margin of 0.75 of the result, and capped at 15%.  For example, given a current EPSmg of $5 and a five years prior value of $3.50, the overall growth would be 42.9%.  The average annual growth over the period would be 8.56%.  Subject to a 0.75 safety of margin-multiple, the estimate of growth would then be 6.42%.  Since this is less than 15%, the cap does not apply.

PEmg Ratio - The PEmg ratio is the Price divided by the EPSmg.

Defensive and Enterprising Investors – Graham taught that a Defensive Investor is one who is not willing or able to take the time to do extremely thorough research.  As a result, the defensive investor must seek companies that have very solid financials in order to minimize the risk of losing an investment.  An Enterprising Investor is willing and able to do more research on potential investments, and as a result is able to take on slightly higher risk through investing in companies that do not hold as strong financial positions.  Graham suggested some basic requirements for each type of investor, and we have updated those requirements to fit today’s marketplace.  Every company valued by ModernGraham must go through a series of tests to determine whether it would be suitable for a Defensive Investor or an Enterprising Investor.  If it is not suitable for either type of investor, the company is deemed to be speculative.

 

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