The core of value investing is to obtain an investment for less than its worth. Professional investors will typically focus on the price to earnings (P/E) ratio which compares the current share price with its per share earnings. Although this is a good gauge, more than one ratio should be considered when assessing an investment. Students of value investing should also be familiar with price to book (P/B) ratio. This ratio (P/B) compares the current share price to the current shareholder equity.
In the book The Intelligent Investor, Benjamin Graham highlights a key concept which combined the two ratios [P/E and P/B] as a gauge on the valuation of a company. These combined ratios are known as the Graham ratio. The computation is elementary, simply multiply the P/E ratio with the P/B ratio. If the product is less than 22.5, the company may be of good value. This thesis is highlighted in Chapter 14 – Stock Selection for the Defensive Investor of The Intelligent Investor. We find this concept to be so compelling that we've decided to back test this ratio against our watch lists from 2012.
We started with our U.S. Dividend Watch Lists from May 11, 2012 through August 24, 2012 and compared the share price after two years. Because many companies appeared on our list multiple times, we selected only the instances with the least amount of return. We then split the list into two sections, one with companies that meet the Graham ratio and others that fail. We believe the results are distinct and worth reviewing.
Each list contains 31 companies. The list of companies meeting the Graham ratio criteria of less than 22.5 had an average return of +45%. The list of companies with a Graham ratio higher than 22.5 had an average return of +32%. As a result, by simply applying the Graham ratio criteria to our list, we were able to enhance investment returns by +13%. The result can be seen in the table below:
| Meet Graham Ratio? | Yes | Meet Graham Ratio? | No | |
| Company | % Change | Company | % Change | |
| 1st Source Corp. | 45% | Air Products & Chemicals | 52% | |
| ABM Industries | 30% | Becton, Dickinson and | 53% | |
| American National Insurance | 53% | Bemis Co Inc | 37% | |
| Applied Materials | 90% | C.H. Robinson Worldwide | -4% | |
| Archer Daniels Midland | 82% | California Water Service | 20% | |
| Arrow Financial Corp. | 7% | Carbo Ceramics | 59% | |
| Bank of Montreal | 22% | Cardinal Health | 61% | |
| Clorox | 27% | ConAgra Foods | 24% | |
| ConocoPhillips | 45% | Connecticut Water Service | 21% | |
| Energen Corp. | 119% | Erie Indemnity Company | 9% | |
| Energy Transfer Partners L P | 34% | Expeditors International | 6% | |
| First Financial Corp. | 10% | Hill-Rom Holdings | 51% | |
| First Niagara Financial Group | -1% | HJ Heinz | 36% | |
| Goldman Sachs Group | 73% | Hormel Foods Corp. | 61% | |
| Harte-Hanks | 4% | John Wiley & Sons CL 'A' | 21% | |
| Hill-Rom Holdings | 52% | Johnson & Johnson | 57% | |
| IBERIABANK Corp. | 34% | Matthews International Corp. | 28% | |
| Johnson Controls Inc | 90% | McDonald's Corp. | 5% | |
| Legg Mason | 100% | Middlesex Water Company | 11% | |
| Matthews International Corp. | 34% | National Fuel Gas | 63% | |
| McGrath RentCorp. | 45% | New Jersey Resources Corp. | 14% | |
| Mercury General Corp. | 34% | Owens & Minor | 16% | |
| Murphy Oil Corporation | 51% | Pitney Bowes Inc | 95% | |
| PP&L Corporation | 15% | Procter & Gamble | 26% | |
| RLI Corp. | -32% | SJW Corp. | 15% | |
| S&T BanCorp. | 41% | South Jersey Industries | 14% | |
| Telephone and Data Systems, Inc | 25% | Sysco Corp. | 33% | |
| Tompkins Financial Corp. | 26% | Tootsie Roll Industries Inc | 25% | |
| UniSource Energy Corporation | 66% | United Technologies Corp. | 56% | |
| Unum Group | 54% | Weyco Group | 12% | |
| Walgreen | 107% | WGL Holdings | 3% | |
| Number of Companies | Average | Number of Companies | Average | |
| 31 | 45% | 31 | 32% |
While it is not our goal to base a final decision to buy a dividend paying stock on a single ratio, we find the overall concept a useful means for identifying ideal investment candidates. Keep in mind that Warren Buffett said in his 2013 shareholder meeting that he does not invest based on a simple ratio.
Warren Buffett prefers management first and financial considerations second. Our selection of consecutive dividend increasing stocks partially addresses the issue of management since executives must consider whether they can grow the company after "giving away" some portion of the company's cash. Successful and efficient managers are those who can increase profits and dividends without harming the sustainability of the business.
For the Graham ratio stocks that passed the test (22.5 or less), even if the stocks with triple digit returns were excluded ( 3 stocks), they still exceeded the return of those that failed the Graham ratio test (+34% v. +32%). It should also be noticed that while there were two stocks that passed the Graham ratio test with negative returns, the overall list of stocks that passed the Graham ratio review still outperformed, on average.
Clearly, the Graham ratio isn't a cure-all for the investment selection process. However, we believe adding the Graham ratio to the selection process could improve the overall returns on investment.