Benjamin Graham, Public-Utilities and Financial Enterprises

The Value Investing framework of Warren Buffett's mentor can also be used to evaluate Banks, Insurance Companies and other stocks that don't report Current Assets and Current Liabilities.

What Graham Wrote

Graham gave the following instructions on the subject of analyzing Utilities and Financials, which are structurally different from other types of stocks.

Public-Utilities

"1. Adequate Size of the Enterprise... not less than $50 million of total assets for a public utility."

"2. A Sufficiently Strong Financial Condition.. For public utilities the debt should not exceed twice the stock equity (at book value)."

Chapter 14: Stock Selection for the Defensive Investor, The Intelligent Investor.

Total Assets ≥ $250 Million

Criterion #1 above works out to about $250 million of Total Assets today, when adjusted for inflation.

No Current Assets or Liabilities

"The Public-Utility “Solution”...We exclude one criterion from our tests of public-utility stocks—namely, the ratio of current assets to current liabilities. The working-capital factor takes care of itself in this industry as part of the continuous financing of its growth by sales of bonds and shares. We do require an adequate proportion of stock capital to debt."
Chapter 14: Stock Selection for the Defensive Investor, The Intelligent Investor.

Equity:Debt

The [2 x Equity] ÷ Debt rating on Serenity is simply a variation of of the standard Debt-To-Equity Ratio – D/E. This Graham Rating is based on Graham's recommendations for "stock equity" or "stock capital" (also a common accounting term).

The rating is simply calculated as:

[2 x Equity] ÷ Debt = 2 x (Total Assets - Total Liabilities) ÷ Total Liabilities

Financial Enterprises

"Investing in Stocks of Financial Enterprises... counsel that the same arithmetical standards for price in relation to earnings and book value be applied to the choice of companies in these groups as we have suggested for industrial and public-utility investments."
Chapter 14: Stock Selection for the Defensive Investor, The Intelligent Investor.

Screening

Serenity's free Classic Graham Screener follows Graham's standard 17-rule Value Investing framework. The Advanced Graham Screener has additional filters which — when used in combination with the standard Graham rules — allow for the screening of Utilities and Financials.

Advanced Filters

Graham Ratings on Serenity are defined such that they're better when higher, and that Graham's Defensive requirements default to 100%. However, considering prevailing Interest Rates, a Graham Number(%) of 70% may be sufficient for a Defensive grade stock to clear Graham's criteria.

The filter values on the Advanced Graham Screener for Utilities and Financials would therefore be:

Earnings Stability (100% ⇒ 10 Years) ≥ 100%
Dividend Record (100% ⇒ 20 Years) ≥ 100%
Earnings Growth (100% ⇒ 33% Growth) ≥ 100%
[2 x Equity] ÷ Debt ≥ 100%
Size in Assets (100% ⇒ 250 Million) ≥ 100%
Graham Number(%) ≥ 70%
Analyst Serenity

Note-1: For Financial Enterprises, the filter Size in Assets (100% ⇒ 250 Million) ≥ 100% can be substituted with the usual Defensive grade filter of Size in Sales (100% ⇒ 500 Million) ≥ 100%.
Note-2: Many of the stocks listed by the above filters may be marked Ungraded because they do not clear the standard framework.

Sectors

The filter for Sectors is not included here because certain stocks which would not necessarily be classified as Utilities or Financials — such as Real Estate Investment Trusts (REITs) — also need to be screened using the above criteria.

Utilities and Financials can also not be included in the default Defensive grading system precisely for this reason; because their specifications cannot be applied to automatically determinable sectors.

The rules for Utilities and Financials are thus an advanced customization of Graham's standard Defensive rules, and so only supported by the Advanced Graham Screener.

Note: Graham himself wrote that Utilities were more likely to clear his Defensive criteria, than were Industrials and other types of stocks.

Utilities and Financials are thus evaluated using Total Assets and Equity:Debt, unlike regular Defensive grade stocks.

Comments

Hello,I've been searching a month which formula should I use to test the public utilities for their financial condition. The sentence 'the debt should not exceed twice the stock equity (at book value)' is whether just pasted without explanation or said to be ambiguous. What exactly is 'debt'? 'Short-Term Debt'? 'Long-term Debt'? (the only two values containing the term 'debt' within the gurufocus definitions section). And what about 'book value': 'Tangible Book Value' or simply 'book value'? I ended up building the following formula: 0 ≤ Total Liabilities/ (Total Assets - Intangible Assets - Total Liabilities) ≤ 2 but I have doubts... I have just the feeling that no one understand it and everybody is avoiding the problem....Could you please help me to solve the problem?

Hello Francesca,

Graham always uses specific terms such as net tangible assets, Long-term debt etc wherever applicable. So it should be safe to assume that Graham means Book Value and Total Liabilities here.

The [2 x Equity] ÷ Debt rating on Serenity uses:
2 x (Total Assets - Total Liabilities) ÷ Total Liabilities

So for a Public Utility to qualify as Defensive, it would need to have:
Equity:Debt > 100%

Hello Serenity

Ok, so if a utility of financial enterprise clear the levels
1. Earnings Stability (100% ⇒ 10 Years):
2. Dividend Record (100% ⇒ 20 Years):
3. Earnings Growth (100% ⇒ 33% Growth):
4. [2 x Equity] ÷ Debt:
5. Size in Assets (100% ⇒ 250 Million):

What would one use for instrinsic value? Graham number? Enterprise number? NCAV number?

I'm in the middle of reading The Intelligent Investor... but I don't feel intelligent about this :).

I'll make a guess. IF the utility / financial enterprise passes the size in assets ($50 million then, $250 million now) then Graham number.
If it doesn't meet that first of criteria, but does meets these (essentially the Enterprising criteria, with the size factor removed):
1. Earnings stability: No deficit in the last five years covered in the Stock Guide. (no negative EPS)
2. Dividend record: Some current dividend.
3. Earnings growth: Last year's earnings more than those of 1966. (4 years ago)
4. Price: Less than 120% net tangible assets.
5. [2 x Equity] ÷ Debt:
then it's an Enterprising utility / financial enterprise, and should use the Serenity number.

If it doesn't meet even that criteria, then
[1.] price less than the applicable net current assets ( / shares outstanding)
[2.] Eliminated those which had reported net losses in the last 12-month period. (EPS (TTM) >0
Then the NCAV number is used. (and maybe there is a 4th level. 2/3 price as you mentioned elsewhere on your excellent site.)

Is my guess wildly off in your view? If yes, how do you determine the levels, and the intrinsic value, for a utility / financial sector?

I look forward to your answer.

T

Dear Tranquility,

Thank you for your comment!

The Intrinsic Value for Public-Utilities and Financial Enterprises too are determined based on the Graham Number, as described in the section on Advanced Filters in the main post above.

The rules for Utilities and Financials are simply a customization of Graham's standard Defensive rules, as described in the section on Sectors above.

Dear Serenity,

The utility criteria is very clear. However, I find the financials criteria to be more ambiguous.

Since with regards to financials, Graham's only comment is that:

"Investing in Stocks of Financial Enterprises... counsel that the same arithmetical standards for price in relation to earnings and book value be applied to the choice of companies in these groups as we have suggested for industrial and public-utility investments."

How do we know that the test for size in sales for financials should not also be applied? Why would it be the test for total assets?

Best,
Daniel

Dear Daniel,

Thank you for your thoughtful comment!

Graham writes:

"To be “large” in present-day terms a company should have $50 million of assets or do $50 million of business."

Chapter 5: The Defensive Investor and Common Stocks, The Intelligent Investor.

So it appears the two criteria are interchangeable for the most part.

Serenity uses the Size in Assets (100% ⇒ 250 Million) ≥ 100% here for Financial Enterprises, simply for the sake of uniformity; since Utilities and Financials already share commonalities with regards to Capital Structure.

But you're right!

Graham does not say anything specific on the matter and the default Size in Sales (100% ⇒ 500 Million) ≥ 100% criteria could just as well be used for Financial Enterprises. A note to that effect has been added on the main post as well.

Thank you again for your comment!

Graham Resources