Imagine yourself as a businessman. You have all the necessary financial data regarding the company – historical earnings, assets, and liabilities. But when would you buy that company?

Surely, you would buy it when the price you are getting is sufficiently less than your calculated value of that company. Right? But now, the question arises - how do you value that company?

Before delving into the valuation part, let us highlight two important aspects of the scenario. Firstly, we are talking about purchasing the whole company instead of just its stock, i.e., thinking like a businessman. Secondly, we are talking about purchasing a company at a price lower than our estimated value, i.e., the margin of safety. These are two of the most important characteristics of value investing. For more details, please refer to article #1.

Now, let's talk about the valuation part. There are two ways in which you can value the business.

The first way is to have a deep understanding of the business by examining its past financial performance, growth, business strategy, competitive positioning, and management. Ultimately, estimating the future earnings/cash flows is crucial. The sum of the future cash flows discounted back at appropriate rates would give us the present value of that company. If the prevailing price is less than that value, it is a buy.

The second way is to roughly estimate the value of the tangible assets of the company instead of estimating the future earnings. This value would depend somewhat on the book value and the general prospects of the business. If the prevailing price is less than that value, it is a buy.

The second way is what Mr. Benjamin Graham used to practice, and it is this one that we are going to view in detail in this article. The references for the below discussions are the books written by him – “Security Analysis” and “The Intelligent Investor”.

Mr. Graham doesn’t like the idea of valuing the company based on future estimates much. He believes the future is not something to be estimated but rather to be protected from. In "The Intelligent Investor," he writes, “The intelligent analyst will confine himself to those groups in which the future appears reasonably predictable, or where the margin of safety of past performance value over current price is so large that he can take his chances on future variations - as he does in selecting well-secured senior securities.”

He has laid out his investment philosophy in chapters 4-7 and 11-15. He describes his operations in common stocks under four heads:

1. Buying carefully chosen stocks
He suggests the investor buy only sound stocks. Soundness in terms of adequate size of the company, sufficiently strong financial position (i.e., in terms of long-term debt and working capital), and no earnings deficit in the past ten years.

2. Buying the bargains
He suggests purchasing those sound stocks at a sufficiently low price in relation to the assets of the company. Price of stock no more than 1.5 times net asset value. Price no more than 15 times average earnings of the past three years. This generally happens when either the overall market is low or the industry is not performing well.

3. Buying the various types
He suggests purchasing from various industries, scales of operations, and creating a diversified portfolio of stocks.

4. Repeating the process for a long duration.

He also suggests a few areas of operations where the investor can work. It includes:

The Relatively Unpopular Large Company
The investor can work on the larger companies that are going through a period of unpopularity - companies that are out of favor because of unsatisfactory developments of a temporary nature. Many times, market prices these types of companies at an extremely low price, which may provide an opportunity for the investor. The market is likely to respond to any improvement shown.

Purchase of Bargain Issues
Because of the poor current earnings and poor immediate prospects, companies can be traded at below their net current assets or working capital. These may also provide opportunity for the investor to purchase. According to Mr. Graham, “To be as concrete as possible, let us suggest that an issue is not a true bargain unless the indicated value is at least 50% more than the price.”

Bargain Issue Pattern in Secondary Companies
Secondary companies are those that are not leaders in fairly important industries. Substantial profits from the purchase of secondary companies at bargain prices can be made in a variety of ways. First, the dividend return is relatively high. Secondly, the reinvested earnings are substantial in relation to the price paid.

Practice, Practice, Practice
Now, it is upon the investor to keep practicing this philosophy and refining them as he learns.

Disclaimer: The above are our personal thoughts and take out from the book. We try to apply these thoughts to our investment operation. We are sure that there are several more ideas that can be taken out from the book. Also, we can be wrong in our thinking or that our thinking can change in the future as we learn more. So. Let's move forward with a sense of skepticism.