Stock selection for defensive investors: seven criteria


In his book, The Intelligent Investor, Benjamin Graham suggested seven quality and quantitative criteria for the selection of common stocks for a defensive investor’s portfolio.

The seven suggested criteria are:

  1. Adequate size of the enterpise.
  2. A sufficiently strong financial condition.
  3. Earnings stability: No earnings deficit in the past ten years.
  4. Dividend record: Continued dividends for at least the past 20 years.
  5. Earnings growth: Ten-year growth of at least one-third in per-share earnings, using three-year averages at the beginning and the end.
  6. Moderate price/earnings ratio: Current price should not be more than 15 times average earnings of the past three years.
  7. Moderate ratio of price to assets: Current price of stock should be no more than 1.5 times the book value (he mentioned this as “net asset value” in an earlier chapter) last reported.

Let’s zoom in on criteria (6) and (7) above.

Moderate ratio of price to assets: Current price of stock should be no more than 1.5 times the book value (he mentioned this as “net asset value” in an earlier chapter) last reported. “However,'” said Benjamin Graham, “a multiplifier of earnings below 15 could justify a corresponindly higher multiplier of assets.”

“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 times.”

Benjamin Graham elaborates: “This figure of (22.5 times) corresponds to 15 times earnings and one-and-a-half times book value. It would admit an issue selling at only 9 times earnings and 2,5 times asset value etc.”

P/S Crtiteria (6) and (7) should therefore be read in conjunction. When book value exceeds 1.5 times, it has to be compensated by a fall in the price/earnings ratio of 15. The product of book value and the pice-earnings ratio should not exceed 22.5 times).