Lesson 3 of 8
The Intelligent Investor
The seven tests Graham printed for a defensive investor in the 1973 revision, the two multiples that had to be multiplied together, and Mr Market.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The 1973 revision prints seven tests for a defensive investor, and joins the last two: a P/E under 15 may carry more than 1.5 times book, never the reverse.
- Chapter 12 argues that reported per-share earnings are shaped by choices, so several years averaged say more than one year reported.
- Chapter 8 hands you a business partner who quotes a price daily, and says the price is an offer rather than a measurement.
The Intelligent Investor is the same tradition written for one person rather than for a profession. The edition this academy cites is the revised edition of 1973, and its most useful pages are the ones that print numbers.
The seven tests for a defensive investor
| Test | The line Graham printed |
|---|---|
| Size | Adequate size, to avoid the smallest companies |
| Financial condition | Current ratio at least 2.0, and for an industrial, long-term debt not exceeding net current assets |
| Earnings stability | Positive earnings in each of the past ten years |
| Dividend record | Uninterrupted payments for at least the past twenty years |
| Earnings growth | At least one third in per-share earnings over ten years, measured on three-year averages at each end |
| Price against earnings | At most 15 times the average earnings of the past three years |
| Price against assets | At most 1.5 times book value |
The test most people get wrong
The last two are not two separate lines. Graham let the second one bend: a P/E under 15 can justify paying more than 1.5 times book, provided the product of the two multiples does not exceed 22.5. A company at 12 times average earnings and 1.8 times book passes, because 12 multiplied by 1.8 is 21.6. A company at 14 times earnings and 1.8 times book fails, because that product is 25.2, even though it is under 15 on the first line.
The bend runs one way. The earnings line stays at 15 whatever the book multiple, so a company at 18 times average earnings fails it even at 1.2 times book, where the product is only 21.6. Cheapness against earnings can buy room on book value; cheapness against book cannot buy room on earnings.
Averages, not years
Chapter 12 is the reason the price test says average earnings of the past three years rather than last year's. Reported per-share earnings are shaped by special charges, by tax treatment and by depreciation choices, all of them decided by the company doing the reporting. Averaging several years does not remove that. It reduces the weight any single year's choices carry.
The same instinct runs through every later attempt to smooth the denominator of a multiple, including the ten-year average Shiller and Campbell used.
Price as an offer
Chapter 8 makes the market a partner in a private business who turns up every day and names a price at which he will buy your share or sell you his. He is not appraising the business. He is quoting a price, and his mood sets it.
The practical content is narrow and exact: a quote obliges you to nothing. A falling quote is not information about the business unless you can name what changed in the business. That is the whole of it, and it is why this book is readable by a person with no training.
What the book does not contain
It contains no discounted cash flow practice, no return on invested capital threshold, and nothing resembling the phrase economic moat. Those arrived later and from other people. A claim of the form "Graham said" that involves any of them is a claim about a book that does not say it.
Check yourself
A company trades at 14 times its three-year average earnings and 1.8 times book value. What does Graham's joint rule say?
- It passes, because 14 is below 15
- It fails, because the product of the two multiples is 25.2, above 22.5
- The rule does not apply to companies above book value
Show the answer
Answer: B.
The two multiples are multiplied together and compared with 22.5. Passing one line alone is not the test.Why does the price test use three-year average earnings rather than the latest year?
- Because the latest year is usually unaudited
- Because reported per-share earnings are shaped by choices the company makes, and averaging reduces the weight of any single year
- Because three years is the maximum a filing contains
Show the answer
Answer: B.
Chapter 12 argues that special charges, tax treatment and depreciation choices shape the reported figure, so several years averaged carry more information than one.What is the practical content of the Mr Market idea?
- That falling prices signal falling business quality
- That a quote is an offer you are free to ignore, and is not information about the business on its own
- That you should trade more often when prices move
Show the answer
Answer: B.
The partner quotes a price and his mood sets it. A move in the quote becomes information only when you can name what changed in the business.Sources
- Graham, The Intelligent Investor, revised edition 1973, chapter 14: the seven criteria for a defensive investor, including the joint limit of 22.5 on the product of the two multiples.
- Graham, The Intelligent Investor, revised edition 1973, chapter 12: reported per-share earnings are shaped by special charges, tax treatment and depreciation choices.
- Graham, The Intelligent Investor, revised edition 1973, chapter 8: the market as a business partner quoting a price daily.
- Shiller, Irrational Exuberance, 2000, and the cyclically adjusted price to earnings ratio developed with John Campbell.
What this leaves out
- This lesson cites the revised edition of 1973. It does not compare that edition with the 1949 first edition line by line, because this academy holds only the revision, and a claim about what changed between editions would be a claim about a text nobody here has read.
- Both worked examples use invented round numbers and are labelled illustrative.
- The criteria are reported as printed. Whether any of them is available in a given market at a given time is an empirical question, and lesson 8 puts one of them against a dated cohort.
- Nothing here is advice about any security.