The *Value Investing* framework of Warren Buffett's mentor allows for P/E ratios of *30* and more based on prevailing *Interest Rates*.

## What Graham Wrote

Graham recommended a *P/E ratio* no higher than *13.3* based on an *AA Bond Yield* of *7.5%*.

"Our basic recommendation is that the stock portfolio, when acquired, should have an overall earnings/price ratio—the reverse of the P/E ratio—at least as high as the current high-grade bond rate. This would mean a P/E ratio no higher than 13.3 against an AA bond yield of 7.5%."

Based on the same principle, a defensive investor in the U.S. today could consider stocks with *P/E ratios* up to *30*, since *10-year AA Corporate Bond Yields* are now close to *3.3%*.

*100 ÷ 7.5 = 13.3*

*100 ÷ 3.3 = 30*

## Some Quick Math

Adjusting Graham's framework to screen *Defensive* grade stocks with *P/E ratios* of *30* instead of *15* (all else being equal) would involve the following:

*30 ÷ 15 = 2*

*√2 = 1.41*

We would need to multiply the *Graham Number* of a stock by *1.41*, to adjust it to a *P/E* of *30*.

Note: Since the *Graham Number* is designed to balance *Earnings* and *Assets*, stocks with *P/E* values higher than *30* could clear Graham's rules too if they have lower *P/B* values.

## Screening

### a. Defensive

The filter values required on *Serenity*'s screeners for finding *Defensive* grade stocks with the adjusted *Graham Number* would be:

**Graham Grade**

*Defensive*

**Graham Number(%) ≥**

*70%*

*Graham Number(%)* is *Graham Number ÷ Previous Close*.

The reciprocal of *1.41* is *0.70*, or *70%*. So a stock with a *Graham Number(%)* of *70%* or more will have a *Previous Close* that is *1.41* times its calculated *Graham Number* or less.

### b. Enterprising

Prices for *Enterprising* grade stocks will have to be adjusted similarly.

*Intrinsic Value* is the price corresponding to a stock's *Graham Grade*: *Defensive*, *Enterprising* or *NCAV (Net-Net)*. For *Enterprising* grade stocks, *Intrinsic Value* = *Serenity Number*.

*Intrinsic Value(%)* is *Intrinsic Value ÷ Previous Close*, expressed as a percentage. *Serenity*'s *Advanced Graham Screener* has a filter specifically for *Intrinsic Value(%)*.

Considering current *Interest Rates*, *Defensive* and *Enterprising* grade U.S. stocks would need an *Intrinsic Value(%)* of *70%* or higher to be classified as true Graham stocks today. This customization may differ for for non-U.S. economies.

### c. NCAV (Net-Net)

*NCAV (Net-Net)* grade stocks will require *Intrinsic Values* of *100%* or higher. The *NCAV Price* is calculated based on asset values alone, which — unlike earnings yields — are not dependent on bond rates.

## Buffett Explains

### Interest Rates ≈ Gravity

"Look at one of the two important variables that affect investment results: interest rates. These act on financial valuations the way gravity acts on matter: The higher the rate, the greater the downward pull. That's because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities. So if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward. The basic proposition is this: What an investor should pay today for a dollar to be received tomorrow can only be determined by first looking at the risk-free interest rate.

Consequently, every time the risk-free rate moves by one basis point — by 0.01% — the value of every investment in the country changes. People can see this easily in the case of bonds, whose value is normally affected only by interest rates. In the case of equities or real estate or farms or whatever, other very important variables are almost always at work, and that means the effect of interest rate changes is usually obscured. Nonetheless, the effect — like the invisible pull of gravity — is constantly there."

### Intrinsic Value ∝ Bond Yields

Warren Buffett explains how the *Intrinsic Value* of a stock is dependent on prevailing *Interest Rates* and *Bond Yields*.

*Submitted by serenity. Updated on Thursday 13th August 2020.*

## Comments

## Graham Number

Based on this and how the advanced screener calculates GN, should we be looking at 1.46*GN versus previous close when considering margin of safety from a dollars perspective?

## 70%

That's correct, LearningGraham!

The way to do that on

Serenity'sscreeners is to screen forDefensiveandEnterprisinggrade stocks withIntrinsic Value(%)greater than 70%.Also, for

Defensivegrade stocks,Intrinsic Value=Graham Number.## Margin of Safety, Earning Yield vs Bond Yield

I believe Buffet said once that a good way to see the value of a stock is by comparing its earning yield vs 10 years treasury yield. If earning yield is at least 2x the current 10 years treasury yield it is a good buy. For example, 10 years treasury yield right now is 2.3%, which means if we buy a stock with P/E of 21.74 (4.6% earning yield), that's a good buy.

It is tough to find bargain nowadays. Dow hit all time high. S&P 500 index P/E ratio is 26.16.

## Hundreds of Graham Stocks

Thank you for your informative comment, Will!

Serenity'sscreeners list hundreds of stocks that completely clear Graham's requirements as of today.