The Value Investing framework of Benjamin Graham — Warren Buffett's mentor — uses a combination of the Price-to-Earnings and Price-To-Book ratios, giving more comprehensive insight than either ratio used alone.
Earnings Per Share (EPS) indicates how much profit the company makes per share.
EPS combined with Price gives an idea of the rate of return one can expect on one's investment. EPS and Price are usually measured together as the P/E ratio, or Price-to-Earnings ratio.
Book Value Per Share (BVPS) is the theoretical liquidation value of the stock. BVPS indicates how much one would be paid per share if the company were to close tomorrow.
BVPS combined with Price gives a rough idea of the collateral on one's investment. BVPS and Price are usually measured together as the P/B ratio, or Price-to-Book ratio.
Graham required that a stock for Defensive investment should have:
6. Current price should not be more than 15 times average earnings of the past three years.
7. Current price should not be more than 1½ times the book value last reported.
As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5.
These two rules together yield what is known today as the Graham Number.
Note: The "multiplier" Graham refers to is simply another term for the P/E Ratio.
Versatility Across Sectors
The Graham Number is designed to assess stocks regardless of sector. Companies from low-earnings industries such as Utilities will need higher asset figures, and those from low-asset ones such as Financial Services will need higher earnings figures.
"It has long been the prevalent view that the art of successful investment lies first in the choice of those industries that are most likely to grow in the future and then in identifying the most promising companies in these industries... The author did not follow this approach in his financial career as fund manager, and he cannot offer either specific counsel or much encouragement to those who may wish to try it."
But the Graham Number too, despite its higher versatility, is part of a framework and not meant to be used in isolation.
Graham Number(%) is Graham Number ÷ Previous Close.
So a stock with a Graham Number(%) of 200% will have a P/E value of 7.5 and a P/B value of 0.75 — or a higher value in one corresponding to a lower value in the other — yielding a total multiple of 5.625 (22.5 ÷ 2²).
Graham Number(%) is thus a combination of the Price-to-Earnings and the Price-To-Book ratios, and yields better results than either ratio used on its own.
For more Enterprising (or aggressive) investors, Graham recommended:
"issues selling at multipliers under 10... Price: Less than 120% net tangible assets."
These rules yield a similar price calculation, referred to on Serenity as the Serenity Number.
Intrinsic Value(%) is Intrinsic Value ÷ Previous Close.
The Intrinsic Value of an Enterprising grade stock is its Serenity Number.
An Enterprising grade stock with an Intrinsic Value(%) of 200% will have a P/E value of 5 and a P/B (tangible) value of 0.6 — or a higher value in one corresponding to a lower value in the other — yielding a total multiple of 3 (12 ÷ 2²).
The below Preset Links will load Serenity's two Graham screeners with stocks having Graham Number(%) higher than 200% and Intrinsic Value(%) higher than 200% respectively.