Security analysis for the lay investor
How Graham tested a bond's safety, his simple growth-stock formula, and Zweig's warning signs in a company's reports.
FinanceGraham ch. 11About 4 min: 2 reading, 2 practiceUpdated
General education, not financial advice.
- Calculate interest coverage and compare it with Graham's standards
- Apply Graham's simplified growth formula and explain its limits
- List warning signs and good signs Zweig looks for in a company's reports
The Intelligent Investor: Benjamin Graham's ideas: lesson 12 of 24
- Graham ch. 1
- Investment versus speculation 4 min
- Graham ch. 2
- Inflation and the investor 4 min
- Graham ch. 3
- A century of market history 5 min
- Graham ch. 4
- The defensive investor's portfolio 4 min
- Graham ch. 5
- Defensive investors and stocks 4 min
- Graham ch. 6
- What the enterprising investor avoids 4 min
- Graham ch. 7
- What the enterprising investor does 5 min
- Graham ch. 8
- Mr. Market 5 min
- Living with fluctuations 5 min
- Graham ch. 9
- Investing in funds 5 min
- Graham ch. 10
- The investor and his advisers 4 min
- Graham ch. 11
- Security analysis for the lay investor 4 min
- Graham ch. 12
- Per-share earnings and their traps 4 min
- Graham ch. 13
- Comparing four companies 4 min
- Graham ch. 14
- The defensive investor's screen 4 min
- Graham ch. 15
- The enterprising investor's screen 7 min
- Graham ch. 16
- Convertibles and warrants 6 min
- Graham ch. 17
- Four extreme case histories 7 min
- Graham ch. 18
- Eight pairs of companies 7 min
- Graham ch. 19
- Shareholders, managements and dividends 5 min
- Graham ch. 20
- Margin of safety (1): the idea 5 min
- Margin of safety (2): in practice 7 min
- Graham appendix 1
- The superinvestors of Graham-and-Doddsville 6 min
- Graham postscript
- Graham today 7 min
Try first
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Pairs with Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 11, "Security Analysis for the Lay Investor: General Approach"
What it is
Bonds: can the borrower pay? Graham's main test of a corporate bond is interest coverage: how many times the company's earnings cover its total interest charges, averaged over several years. His recommended minimums for an investment-grade bond, before income tax, include:
| Type of company | Average of past 7 years | Or: poorest year |
|---|---|---|
| Public utility | 4 times | 3 times |
| Railroad | 5 times | 4 times |
| Industrial | 7 times | 5 times |
| Retailer | 5 times | 4 times |
Stocks: a simple growth formula. For growth stocks, Graham offers a deliberately simplified formula:
Value ≈ current normal earnings × (8.5 + 2 × expected yearly growth rate)
with growth taken over the next seven to ten years. So a company with no growth is worth about 8.5 times earnings; one expected to grow 10% a year, about 28.5 times. Graham presents it as a shortcut that gives figures close to more elaborate calculations, not as precise truth.
Quick check
Tap an answer to check it.
A company earns 3 a share and is expected to grow 5% a year. What does Graham's formula give?
- This is 3 × 8.5, which ignores the growth term; the multiplier is 8.5 + 2 × 5 = 18.5
- This is 3 × (8.5 + 5); the growth rate must be doubled: 3 × (8.5 + 2 × 5) = 55.5
Show answer
55.5. 3 × (8.5 + 10) = 55.5.
Why it matters
Analysis turns "it's a good company" into a question you can check: is the price reasonable for what the business earns, and is its debt safe? Graham also uses the formula the other way round: from the price, work out what growth the market is assuming, and ask whether it's believable.
Worked example
Coverage. An industrial company has averaged earnings before interest and tax of 700 a year over seven years, and pays interest of 100 a year.
- Coverage: 700 ÷ 100 = 7 times: exactly Graham's minimum for an industrial.
Implied growth. A share earns 2 and trades at 49.
- 49 ÷ 2 = 24.5 times earnings. Graham's formula: 8.5 + 2g = 24.5, so g = 8% a year expected for the next 7–10 years. Is that likely? That's the question to ask.
Common mistake
Trusting a precise-looking valuation. Every formula depends on the growth figure you put in, and growth forecasts are where analysts are most often wrong. Zweig warns that a growth rate of around 10% a year before tax may be sustainable for a long time, but that companies promising much more, or showing a sudden burst, usually fade.
Key terms
- interest coverage
- earnings ÷ interest charges: how many times the company can pay its interest
- investment-grade
- judged safe enough for a conservative investor
- capitalisation rate (multiplier)
- the number earnings are multiplied by to estimate value
- implied growth
- the growth rate a price assumes, worked backwards
- moat
- the term Zweig uses for a lasting competitive advantage
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| interest coverage | earnings ÷ interest charges: how many times the company can pay its interest |
| investment-grade | judged safe enough for a conservative investor |
| capitalisation rate (multiplier) | the number earnings are multiplied by to estimate value |
| implied growth | the growth rate a price assumes, worked backwards |
| moat | the term Zweig uses for a lasting competitive advantage |
Practice
Work it through
A share earns 4. You expect 6% growth a year for the next decade. The price is 70.
- 8.5 + 2 × 6
- 4 × 20.5
- (70 ÷ 4 − 8.5) ÷ 2
Sort it
In Zweig's commentary, a warning sign or a good sign in a company's reports?
Buys more than two or three other companies every year
A "serial acquirer".Show answer
Warning sign. A "serial acquirer".
Keeps raising money by borrowing or selling shares because its business doesn't produce enough cash
Living on other people's money.Show answer
Warning sign. Living on other people's money.
Most of its sales come from one customer
Too dependent on one buyer.Show answer
Warning sign. Too dependent on one buyer.
A lasting advantage competitors can't easily copy
A wide "moat".Show answer
Good sign. A wide "moat".
Sales and profits that have grown steadily for ten years
A marathoner, not a sprinter.Show answer
Good sign. A marathoner, not a sprinter.
In short
- Bond safety: interest coverage, averaged over years; Graham's minimums vary by type of company (industrials: 7× average or 5× in the worst year, before tax).
- Graham's growth formula: value ≈ earnings × (8.5 + 2g): a shortcut, not a precise truth.
- Work backwards from the price to see what growth it assumes.
- Zweig: watch for serial acquisitions, reliance on outside money and dependence on one customer; look for moats and steady growth.
Mastery check
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Check yourself
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What does Graham's formula say a company with no expected growth is worth?
Show answer
About 8.5 times its normal earnings.
A company's earnings before interest and tax average 500, and its interest is 125. What is its coverage?
Show answer
4 times.
Why is a precise-looking valuation risky?
Show answer
It depends on a growth forecast, and growth forecasts are often wrong.
Further reading
- Benjamin Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 11.
- On this site: Where stock returns come from.
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