A defensive investor today could consider stocks with P/E ratios of 32 — and more — based on current bond yields.
Benjamin Graham — Warren Buffett's mentor and founder of Value Investing — 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 today could consider stocks with P/E ratios up to 32, since 10-year AA corporate bond yields are now close to 3.09% [Feb 2017].
Adjusting Graham's framework to screen Defensive grade stocks with P/E ratios of 32 instead of 15 (all else being equal) would involve the following:
32÷15 = 2.13
√2.13 = 1.46
We would need to multiply the Graham Number of a stock by 1.46, to adjust it to a P/E of 32.
Note: Since the Graham Number is designed to balance Earnings and Assets, stocks with P/E values higher than 32 could clear Graham's rules too if they have lower P/B values.
Serenity's Advanced Graham Screener has a filter specifically for Intrinsic Value(%).
The filter values for finding Defensive grade stocks with the adjusted Graham Number would be:
Intrinsic Value(%): > 70%
70% is used for the Intrinsic Value(%) because the reciprocal of 1.46 is 0.6849, or 68.49%; and Intrinsic Value = Graham Number for Defensive grade stocks.
Prices for Enterprising grade stocks can be adjusted similarly.
NCAV grade stocks require Intrinsic Values of 100% or higher since NCAV Intrinsic Values are calculated based on asset values alone, which — unlike earnings yields — are not dependent on bond rates.
Considering today's bond yields, Defensive and Enterprising grade stocks would need an Intrinsic Value(%) of 70% or higher to be classified as true Graham stocks.
Value Investing 101 provides a list of standard preloads that can be quickly applied to Serenity's Graham screeners.