The Graham And Dodd Method For Valuing Stocks

by: Joe Ponzio posted on: August 16, 2007

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In 1934, David Dodd and Benjamin Graham (Buffett's teacher) wrote what would later be known as the foundation for value investing. Security Analysis knocked Wall Street for focusing on reported earnings and pointed the finger at the brokerages for dismissing their fiduciary responsibilities to clients, ultimately causing the Crash of 1929.

(In reading the latter section, if you didn't know the book was from 1934, you would think he was describing the dot-com boom and bust of the early 2000s. It's actually scary.)

I digress.

The Lessons

Graham and Dodd came up with a method for valuing stocks, primarily looking for deeply depressed prices. Graham and Dodd were looking for stocks that had a high earnings-to-price ration, a low P/E (based on its history), a high dividend yield, a price below its book and net current asset value.

In addition, they wanted to see total debt less than book value, a current ratio greater than two, earnings growth of at least 7% for the past ten years, and no more than a 5% decline in earnings in more than two of those ten years.

The Result

According to Fort Hays State University, the Graham-Dodd method (used by Graham & Dodd in the Graham-Newman hedge fund) produced an annual return to shareholders of 15.5% from 1945-1956. Not bad—except the S&P 500 returned 18.3% for that same period.
How Dare I!

I'm not knocking Graham. All I'm saying is that Graham himself, shortly before his death in 1976, said:

I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham & Dodd" was first published; but the situation has changed...

KISS

Keep it simple. As Buffett says,

There seems to be some perverse human characteristic that likes to make easy things difficult...The business schools reward difficult complex behavior more than simple behavior, but simple behavior is more effective.

Think about that the next time you start to over analyze a stock. If you have to think too hard about it, it probably isn't worth your money.

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