Margin of safety

Margin of safety (safety margin) is the difference between the intrinsic value of a stock and its market price.

Another definition: In Break even analysis (accounting), margin of safety is how much output or sales level can fall before a business reaches its breakeven point.


History

Benjamin Graham and David Dodd, founders of value investing, coined the term margin of safety in their seminal 1934 book, Security Analysis. The term is also described in Graham's The Intelligent Investor. Graham said that "the margin of safety is always dependent on the price paid" (The Intelligent Investor, Benjamin Graham, Harper Business Essentials, 2003).

Application to investing

Using margin of safety, one should buy a stock when it is worth more than its price on the market. This is the central thesis of value investing philosophy which espouses preservation of capital as its first rule of investing. Benjamin Graham suggested to look at unpopular or neglected companies with low P/E and P/B ratios. One should also analyze financial statements and footnotes to understand whether companies have hidden assets (e.g., investments in other companies) that are potentially unnoticed by the market.

The margin of safety protects the investor from both poor decisions and downturns in the market. Because fair value is difficult to accurately compute, the margin of safety gives the investor room for investing.

A common interpretation of margin of safety is how far below intrinsic value one is paying for a stock. For high quality issues, value investors typically want to pay 90 cents for a dollar (90% of intrinsic value) while more speculative stocks should be purchased for up to a 50 percent discount to intrinsic value (pay 50 cents for a dollar).

Application to accounting

In accounting parlance, margin of safety is the difference between the expected (or actual) sales level and the breakeven sales level. It can be expressed in the equation form as follows:

Margin of Safety = Expected (or) Actual Sales Level (quantity or dollar amount) - Breakeven sales Level (quantity or dollar amount)

The measure is especially useful in situations where large portions of a company's sales are at risk, such as when they are tied up in a single customer contract that may be canceled.


Formula

Margin of Safety = Actual Sales - Breakeven Sales

Reference

• Graham, Benjamin. Dodd, David. Security Analysis: The Classic 1934 Edition. McGraw-Hill. 1996. ISBN 0-07-024496-0.
• http://www.businessweek.com/magazine/content/06_32/b3996085.htm
• http://www.worldfinancialblog.com/investing/ben-grahams-margin-of-safety/26/

Notes

1. ^ Yee, Kenton K. (2008). "Deep-Value Investing, Fundamental Risks, and the Margin of Safety". Journal of Investing 17 (3): 35–46. doi:10.3905/JOI.2009.18.1.027.
2. ^ http://www.accountingtools.com/article-metric-margin-of-safet

External links

• http://www.worldfinancialblog.com/investing/ben-grahams-margin-of-safety/26/

From Wikipedia, the free encyclopedia

Margin of Safety - The Three Most Important Words in Investing (Benjamin Graham)

Margin of Safety

1.  Knowing how to compute intrinsic value is just the beginning of valuing a company.

2.  You will be able to appreciate intrinsic value more accurately only when it is deducted from the market price to determine its margin of safety.

3.  Having a margin of safety does not guarantee a successful investment, but it takes care of downside to minimize errors.

4.  It helps to eliminate capital losses or reduce investment risks.

5.  When you have a margin of safety, it will serve as a buffer for any investment and leave room for errors in the event that wrong assumptions were made during the period of valuing a stock.

6.  Capital preservation is the first rule in investing.

7.  We invest only when the risk is reduced to its minimum.

8.  In investing, we need to have good protection (insurance) for our investments - a margin of safety.

9.  The wider the margin, the more protection we will have.

10.  With a margin of safety, the success in investing is not dependent on the exact intrinsic value; the margin of safety serves as better protection against wrong assumptions.

11.  A margin of safety is affected by intrinsic value and the market price.

12.  When the intrinsic value and share price of a company change, the margin of safety will change.

13.  These are three most important terms when using margin of safety:  Undervalued, Fair Value, and Overvalued.

14.  Undervalued:  Intrinsic value $1.  Market price $0.50

15.  Fair value:  Intrinsic value $1.  Market price $1.

16.  Overvalued:  Intrinsic value $1.  Market price $1.50.

17.  There is no hard-and-fast rule regarding how much margin of safety needs to be in place in order for you to become a prudent investor.

18.  Obviously, a 50% margin of safety will generally be better than paying a fair price (0% margin of safety) for the same company.

19.  The wider the margin of safety, the better you will be protected should a financial crisis hit, or when you make a wrong assumption.

20.  However, there are companies, like blue-chip companies that are unlikely to sell at a bargain price with a margin of safety of more than 50%.

21.  Since most blue-chip companies are not growth companies, they will normally trade at a fair price or even be overvalued, rather than being priced at a bargain price, even during times of crisis.

22.  Warren Buffett's statements about quality companies:  "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

23.  The best time to have a great margin of safety is when the market is depressed or when a company is heavily punished by the market due to bad news.

24.  Remember Ben Graham, the market is there to serve us and not to guide us.

25.  You should take such period of market sell-down or stock sell-down as an opportunity to scoop up bargain stocks.

26.  During this period, average investors would not dare to enter the stock market, for fear that prices would continue to drop.

27.  Be greedy when others are fearful!

28.  Understandably, it can be very difficult to make a purchase when the investment mood and environment are shrouded with negativity.

29.  Investors who can overcome this and take action regardless of market pessimism will definitely become very successful.

30.  Teach and prepare yourself to buy growth companies at a low price (undervalued) and sell them ( if you intend to ) when the price is higher or overvalued.

31.  Teach and prepare yourself to avoid buying a stock when it is overvalued (e.g. negative margin of safety).

32.  Warren Buffett once said, "It is better to be approximately right than precisely wrong."

34.  Caution:  Calculating the intrinsic value should be used only to determine WHEN investors want to enter or exit the stock market.  It should not be used to determine the QUALITY of the stock.

35.  The price is mainly determined on market sentiments and not the quality of the stock.

36.  During the 2008-2009 crisis, some growth companies did not continue to grow after the price correction, owing to the respective growth factors of companies.

37.  On the other hand, there are growth companies that continue to grow consistently even in a bear market.



Margin of Safety (Intrinsic value / Market Price)

Positive
>50%         ACTION: BUY (undervalued)
50% - 0%  ACTION:  BUY/HOLD (fair value)

Negative
> -10%      ACTION:  SELL/HOLD (fair value-overvalued)
> - 50%     ACTION:  SELL (grossly overvalued)

Margin of Safety

'Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results.'

Source: "Buffett: The Making of an American Capitalist" (1995)

'If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety.'

Source: 1997 Berkshire Hathaway annual meeting

So, the more vulnerable the business is, assuming you still want to invest in it, the larger margin of safety you'd need. If you're driving a truck across a bridge that says it holds 10,000 pounds and you've got a 9,800 pound vehicle, if the bridge is 6 inches above the crevice it covers, you may feel okay, but if it's over the Grand Canyon, you may feel you want a little larger margin of safety.'

http://www.cnbc.com/id/101000052

http://www.cnbc.com/id/33608379/page/17

If you know the true value of something, buy these only when they're on sale

The basic concept behind value investing is so simple that you might already do it on a regular basis. The idea is that if you know the true value of something you can save a lot of money if you only buy things when they're on sale. 

Buying stocks at bargain prices gives you a better chance at earning a profit later when you sell them. It also makes you less likely to lose money if the stock doesn't perform as you hope. This principle, called the margin of safety, is one of the keys to successful value investing. 

Unlike speculative stocks whose price can plummet, it is less probable that value stocks will continue to experience price declines. 

Value investors don't buy the most popular stocks of the day (because they're typically overpriced), but they are willing to invest in companies that aren't household names if the financials check out. They also take a second look at stocks that are household names when those stocks' prices have plummeted. Value investors believe companies that offer consumers valuable products and services can recover from setbacks if their fundamentals remain strong.

Value investors only care about a stock's intrinsic value. They think about buying a stock for what it actually is - a percentage of ownership in a company. They want to own companies that they know have sound principles and sound financials, regardless of what everyone else is saying or doing.

Value investing is a long-term strategy - it does not provide instant gratification. You can't expect to buy a stock for $66 on Tuesday and sell it for $100 on Thursday. In fact, you may have to wait years before your stock investments pay off. (The good news is that long-term capital gains are taxed at a lower rate than short-term investment gains.)

What's more, value investing is a bit of an art form - you can't simply use a value-investing formula to pick the right stocks which fit the desired criteria. Like all investment strategies, you must have the patience and diligence to stick with your investment philosophy even though you will occasionally lose money.

Also, sometimes you'll decide that you want to invest in a particular company because its fundamentals are sound, but you'll have to wait because it's overpriced. Think about when you go to the store to buy toilet paper: you might change your mind about which brand to buy based on which brand is on sale. Similarly, when you have money saved up to invest in stocks, you won't want to buy a stock just because it represents a share of ownership in your favorite company - you'll want to buy the stock that is most attractively priced at that moment. And if no stock is particularly well priced at the moment, you might have to sit on your hands and avoid buying anything. 

(Thankfully, stock purchases, unlike toilet paper purchases, can be postponed until the time is right.)

A good quality company trading with a large margin of safety

Company OD

Quarter	High Pr	Low Pr	ttm-eps	High PE	Low PE
1	10.18	10.02	72.91	13.96	13.74
4	9.15	9.09	72.67	12.59	12.51
3	9.08	9.02	72.60	12.51	12.42
2	9.22	9.16	70.69	13.04	12.96
1	8.76	8.65	69.27	12.65	12.49
5	8.76	8.65	68.84	12.73	12.57
5	8.71	8.63	67.16	12.97	12.85
5	8.77	8.74	65.56	13.38	13.33
5	8.50	8.35	64.06	13.27	13.03
4	8.74	8.62	61.39	14.24	14.04
3	8.98	8.75	58.74	15.29	14.90
2	8.67	8.62	57.70	15.03	14.94
1	9.27	9.10	56.02	16.55	16.24
4	8.42	7.65	53.95	15.61	14.18
3	7.77	6.94	23.44	33.15	29.61
2	7.00	6.62	15.99	43.78	41.40
1	7.08	6.60	12.33	57.42	53.53
4	6.86	6.31	7.95	86.26	79.35
3	3.72	2.97	35.51	10.49	8.35
2	3.86	3.52	39.10	9.88	8.99
1	4.28	3.39	38.52	11.10	8.81
4	5.48	4.97	40.87	13.42	12.15
3	5.59	4.72	46.21	12.09	10.22
2	4.72	4.41	46.26	10.20	9.54
1	7.28	6.07	47.82	15.23	12.69
4	6.51	6.07	45.75	14.23	13.27
3	6.90	6.57	42.91	16.07	15.30
2	7.17	6.57	41.49	17.29	15.82
1	7.01	6.23	39.46	17.76	15.80
4	6.40	6.12	41.06	15.59	14.91
3	5.96	5.74	37.07	16.07	15.48
2	6.12	5.85	38.01	16.11	15.39
1	6.34	5.90	39.24	16.17	15.04
4	6.46	6.18	37.78	17.09	16.36
3	6.29	6.01	39.27	16.02	15.31
2	6.90	6.12	39.48	17.47	15.51
1	6.62	6.46	38.00	17.42	16.99

Quarter	Q1 eps	Q2 eps	Q3 eps	Q4  eps	FYE eps	Div
0-Jan-00	17.87	0.00	0.00	0.00	17.87	0.00
31/12/2012	17.63	18.64	19.11	17.29	72.67	65.00
31/12/2011	17.20	17.22	17.20	17.22	68.84	36.00
30/06/2011	14.53	15.72	15.60	15.54	61.39	60.00
30/06/2010	12.46	14.04	14.56	12.89	53.95	55.00
30/06/2009	8.08	10.38	7.11	-17.62	7.95	0.08
30/06/2008	10.43	9.80	10.70	9.94	40.87	31.72
30-Jun-07	8.36	11.35	10.76	15.28	45.75	44.14
30-Jun-06	9.96	9.32	9.34	12.44	41.06	46.90
30-Jun-05	8.51	10.55	10.28	8.44	37.78	56.55
				Sum	448.14	395.39
				DPO	88.2%

Latest share price $10.18

ttm-EPS 72.91 sen

Last FY DPS 65 sen

DPO ratio 89.5%

P/E 13.96

DY 6.39%

Historical P/E range 12 - 16

Historical DY range 4.86% - 6.27%

Estimated EPSGR 8% per year

Present risk free interest rate 4%.

Assuming no growth in its earnings or dividends, and using 4% risk free interest rate
as the discount factor, the present value of:
1.  The earnings stream is equivalent to an asset of  72.91 sen / 4% = $18.23
2.  The dividends stream is equivalent to an asset of  65 sen / 4% = $16.25

At present per share price of $10.18, its upside potential is $18.23 - $10.18 = $ 8.05.

Its downside risk is protected by its dividend yield which is equivalent to an asset of $16.25.  This value exceeds its present share price of $10.18 by a substantial margin of $16.25 - $10.18 = $6.07 per share.

That is, its present share price is at 37.45% below its intrinsic value (the value supported by its dividend yields).

Given its good quality of its business and the large margin of safety at the present market price, this stock is a BUY.

Margin of Safety. Paying Up Doesn't Pay Off

Paying Up Doesn't Pay Off
	1999	2004	1999	2004	5-Year	5-Year
	P/E	P/E	Price $	Price $	EPS Growth	Total Return
Coca Cola	47	20	58	42	66%	-28%
Pfizer	42	13	32	27	165%	-16%
Wal-Mart	58	23	69	53	93%	-23%
Dell	75	35	51	42	78%	-18%
Microsoft	78	21	58	27	69%	-53%
Intel	36	21	41	24	-4%	-41%
Cisco	134	24	54	19	100%	-65%
Average	67	22	52	33	81%	-35%

The above chart contains seven of the best businesses in existence.

In the five years from 1999 to 2004, these wonders of American business boosted their earnings per share by an average of 81%, yet had you invested in all of them in 1999, your aggregate return would have been a disappointing negative 35%.

The cause of your loss would be the high price you paid for these businesses in 1999 when their price/earnings ratio averaged a breathtaking 67 times.

By 2004, the average price/earnings ratio had returned to a more rational 22 times, more than offsetting the spectacular gains in earnings per share posted by these corporate giants.

An intelligent investor would have recognized that even for the greatest businesses in the world, at 67 times earnings, Mr. Market was asking too high a price and no margin of safety was available.

MARGIN OF SAFETY

If you had asked Graham to distill the secret of sound investing into three words, he might have replied, "margin of safety/"  These are still the right three words and will remain so for as long as humans are unable to accurately predict the future.

As Graham repeatedly warned, any estimate of intrinsic value is based on numerous assumptions about the future, which are unlikely to be completely accurate.  By allowing yourself a margin of safety - paying only $60 for a stock you think is worth $100, for example - you provide for errors in your forecasts and unforeseeable events that may alter the business landscape.

Just think, if you were asked to build a bridge over which 10,000 pound trucks were to pass, would you build it to hold exactly 10,000 pounds.  Of course not - you'd build the bridge to hold 15,000 or 20,000 pounds.  That is your margin of safety.

Graham’s basic principles of value investing

Value investing

Value investing is a much used phrase and means, in general terms, buying something for less than it is worth. It can apply to just about anything. You can value invest in shares, in bonds, in property, in postage stamps, in vintage cars. The difficulty is in calculating the value of the thing in which you are investing. In many things (postage stamps, collectible cars etc), the only way that value can be determined at any given time is the price that someone is prepared to pay for the item at at that time. The investor in that asset is, as a result, subject to the opinion of others.

Benjamin Graham proposed a method of calculating the value of a stock and Warren Buffett has both applied and enhanced Graham’s approach.

Benjamin Graham: the ‘father of value investing’

It was Benjamin Graham who applied to the theory of investing the concept ofintrinsic value. According to Graham, if you can determine the intrinsic value of a share, then you can ascribe to that share a real value that is not dependent upon the opinion of others (the whims of Mr Market). If you can then buy that share at a price less than its intrinsic value, giving yourself a satisfactory margin of safety, you have made a prudent and rational investment. An investor who holds a diverse portfolio of stocks acquired by this process should, over time, finish ahead.

Benjamin Graham did not apply the term value investment to this investment approach; that has been done by others. He did however called this intelligent investing, indeed the only real form of investing. Buying shares on the basis of value is investing. Buying shares on other bases such as the belief that the market will rise generally, or that a particular industry is good, or that others will bid the price up, is not investment but speculation.

Graham’s basic principles of value investing

In The Intelligent Investor, Graham sets out his strategies for making investments based on value for various types of investor – passive and active, defensive and enterprising – but each approach rests on these basic principles:

• When you buy a stock, you are buying a share in a business.
• The market price of a stock is only an opinion of the value of the stock and does not necessarily reflect the real value of that stock.
• The future value of a stock is a reflection of its current price.
• An investor must always build a margin of safety into the decision to buy a stock.
• Intelligent investing requires a detached and long term approach, based on careful research and reason, and not on the opinions of others or the prospects of short term gains.

Legendary Investor

Benjamin Graham: Three Timeless Principles

Daniel Myers, Investopedia, 02.23.09, 06:00 PM EST

Warren Buffett is the world's richest human. But he may owe it all to his teacher Benjamin Graham.

Benjamin Graham

Warren Buffett is widely considered to be one of the greatest investors of all time, but if you were to ask him who he thinks is the greatest investor, he would probably mention one man: his teacher Benjamin Graham. Graham was an investor and investing mentor who is generally considered to be the father of security analysis and value investing.

His ideas and methods on investing are well documented in his books Security Analysis(1934) and The Intelligent Investor (1949), which are two of the most famous investing books. These texts are often considered to be requisite reading material for any investor, but they aren't easy reads. Here, we'll condense Graham's main investing principles and give you a head start on understanding his winning philosophy.

Principle No. 1: Always Invest With a Margin of Safety

Margin of safety is the principle of buying a security at a significant discount to its intrinsic value, which is thought to not only provide high-return opportunities but also to minimize the downside risk of an investment. In simple terms, Graham's goal was to buy assets worth $1 for 50 cents. He did this very, very well.

To Graham, these business assets may have been valuable because of their stable earning power or simply because of their liquid cash value. It wasn't uncommon, for example, for Graham to invest in stocks in which the liquid assets on the balance sheet (net of all debt) were worth more than the total market cap of the company (also known as "net nets" to Graham followers). This means that Graham was effectively buying businesses for nothing. While he had a number of other strategies, this was the typical investment strategy for Graham. (For more on this strategy, read "What Is Warren Buffett's Investing Style?")

This concept is very important for investors to note, as value investing can provide substantial profits once the market inevitably re-evaluates the stock and raises its price to fair value. It also provides protection on the downside if things don't work out as planned and the business falters. The safety net of buying an underlying business for much less than it is worth was the central theme of Graham's success. When stocks are chosen carefully, Graham found that a further decline in these undervalued equities occurred infrequently.

While many of Graham's students succeeded using their own strategies, they all shared the main idea of the "margin of safety."

Principle No. 2: Expect Volatility and Profit From It

• Warren Buffett

• Philip Fisher

• Benjamin Graham

• Peter Lynch

• Bill O'Neil

• James O'Shaughnessy

• Joseph Piotroski

• John Templeton

• Martin Zweig

• Legendary Investors
• Features
• See Also

Investing in stocks means dealing with volatility. Instead of running for the exits during times of market stress, the smart investor greets downturns as chances to find great investments. Graham illustrated this with the analogy of "Mr. Market," the imaginary business partner of each and every investor. Mr. Market offers investors a daily price quote at which he would either buy an investor out or sell his share of the business. Sometimes, he will be excited about the prospects for the business and quote a high price. Other times, he will be depressed about the business's prospects and will quote a low price.

Because the stock market has these same emotions, the lesson here is that you shouldn't let Mr. Market's views dictate your own emotions or, worse, lead you in your investment decisions. Instead, you should form your own estimates of the business's value based on a sound and rational examination of the facts. Furthermore, you should only buy when the price offered makes sense and sell when the price becomes too high. Put another way, the market will fluctuate--sometimes wildly--but rather than fearing volatility, use it to your advantage to get bargains in the market or to sell out when your holdings become way overvalued.

--Dollar-cost averaging: Achieved by buying equal dollar amounts of investments at regular intervals. It takes advantage of dips in the price and means that an investor doesn't have to be concerned about buying his or her entire position at the top of the market. Dollar-cost averaging is ideal for passive investors and alleviates them of the responsibility of choosing when and at what price to buy their positions. (For more, read "DCA: It Gets You In At The Bottom" and "Dollar-Cost Averaging Pays.")Here are two strategies that Graham suggested to help mitigate the negative effects of market volatility:

--Investing in stocks and bonds: Graham recommended distributing one's portfolio evenly between stocks and bonds as a way to preserve capital in market downturns while still achieving growth of capital through bond income. Remember, Graham's philosophy was, first and foremost, to preserve capital, and then to try to make it grow. He suggested having 25% to 75% of your investments in bonds, and varying this based on market conditions. This strategy had the added advantage of keeping investors from boredom, which leads to the temptation to participate in unprofitable trading (i.e., speculating). (To learn more, read"The Importance Of Diversification.")

Principle No. 3: Know What Kind of Investor You Are

Graham said investors should know their investment selves. To illustrate this, he made clear distinctions among various groups operating in the stock market.

Active vs. passive:Graham referred to active and passive investors as "enterprising investors" and "defensive investors."

You only have two real choices: The first is to make a serious commitment in time and energy to become a good investor who equates the quality and amount of hands-on research with the expected return. If this isn't your cup of tea, then be content to get a passive, and possibly lower, return but with much less time and work. Graham turned the academic notion of "risk = return" on its head. For him, "work = return." The more work you put into your investments, the higher your return should be.

If you have neither the time nor the inclination to do quality research on your investments, then investing in an index is a good alternative. Graham said that the defensive investor could get an average return by simply buying the 30 stocks of the Dow Jones industrial average in equal amounts. Both Graham and Buffett said getting even an average return--for example, equaling the return of the S&P 500--is more of an accomplishment than it might seem.

The fallacy that many people buy into, according to Graham, is that if it's so easy to get an average return with little or no work (through indexing), then just a little more work should yield a slightly higher return. The reality is that most people who try this end up doing much worse than average.

In modern terms, the defensive investor would be an investor in index funds of both stocks and bonds. In essence, they own the entire market, benefiting from the areas that perform the best without trying to predict those areas ahead of time. In doing so, an investor is virtually guaranteed the market's return and avoids doing worse than average by just letting the stock market's overall results dictate long-term returns. According to Graham, beating the market is much easier said than done, and many investors still find they don't beat the market. (To learn more, read "Index Investing.")

Speculator vs. investor:Not all people in the stock market are investors. Graham believed that it was critical for people to determine whether they were investors or speculators. The difference is simple: An investor looks at a stock as part of a business and the stockholder as the owner of the business, while the speculator views himself as playing with expensive pieces of paper with no intrinsic value. For the speculator, value is only determined by what someone will pay for the asset. To paraphrase Graham, there is intelligent speculating as well as intelligent investing--just be sure you understand which you are good at.

Commentary

Graham's basic ideas are timeless and essential for long-term success. He bought into the notion of buying stocks based on the underlying value of a business and turned it into a science at a time when almost all investors viewed stocks as speculative. Graham served as the first great teacher of the investment discipline, as evidenced by those in his intellectual bloodline who developed their own. If you want to improve your investing skills, it doesn't hurt to learn from the best; Graham continues to prove his worth in his disciples, such as Buffett, who have made a habit of beating the market.

Below you will find a table of stocks Forbes recently identified based on the Benjamin Graham screen of the American Association of Individual Investors.

Company	Description	Market Cap ($mil)	Price/Earnings	Yield
Spartan Motors(nasdaq:SPAR -news -people )	Auto & truck manufacturers	152	3.1	2.1%
Euroseas(nasdaq:ESEA -news -people )	Water transportation	168	2.7	14.5
Signet Jewelers(nyse: SIG- news -people )	Retail	608	3.5	538.6
Ternium S.A. (nyse:TX - news- people ) (ADR)	Iron & steel	2,007	2.1	5
United States Steel(nyse: X -news -people )	Iron & steel	4,006	1.9	3.5

Source: AAII Stock Investor Pro

--The price-to-earnings ratio is among the lowest 10% of the database (percent rank less than or equal to 10).
--The current ratio for the last fiscal quarter (Q1) is greater than or equal to 1.5.
--The long-term debt to working capital ratio for the last fiscal quarter (Q1) is greater than 0% and less than 110%.
--Earnings per share for each of the last five fiscal years and for the last 12 months have been positive.
--The company intends to pay a dividend over the next year (indicated dividend is greater than zero).
--The company has paid a dividend over the last 12 months.
--Earnings per share for the last 12 months is greater than the earnings per share from five years ago (Y5).
--Earnings per share for the last fiscal year (Y1) is greater than the earnings per share from five years ago (Y5).
--The price-to-book ratio is less than or equal to 1.2.

http://www.forbes.com/2009/02/23/graham-buffett-value-personal-finance_benjamin_graham.html

Warren Buffett on how to obtain superior profits from stocks.

     An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style.  He can earn them only by carefully evaluating facts and continuously exercising discipline. 

     Common stocks are the most fun.  When conditions are right that is, when companies with good economics and good management sell well below intrinsic business value - stocks sometimes provide grand-slam home runs.  

• We often find no equities that come close to meeting our tests.  
• We do not predict markets, we think of the business.  
• We have no idea - and never have had - whether the market is going to go up, down, or sideways in the near- or intermediate term future.

Warren Buffett: "Avoid these bargains."

Bargain Price

In the final chapter of The Intelligent Investor, Ben Graham wrote:  "Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety." Many years after reading that, I still think those are the right three words. The failure of investors to heed this simple message caused them staggering losses.

    

In the summer of 1979, when equities looked cheap to me, I wrote a Forbes article entitled "You pay a very high price in the stock market for a cheery consensus." At that time skepticism and disappointment prevailed, and my point was that investors should be glad of the fact, since pessimism drives down prices to truly attractive levels. Now, however, we have a very cheery consensus. That does not necessarily mean this is the wrong time to buy stocks: Corporate America is now earning far more money than it was just a few years ago, and in the presence of lower interest rates, every dollar of earnings becomes more valuable. Today's price levels, though, have materially eroded the "margin of safety" that Ben Graham identified as the cornerstone of intelligent investing.

     My first mistake was in buying control of Berkshire. Though I knew its business - textile manufacturing - to be unpromising, I was enticed to buy because the price looked cheap. Stock purchases of that kind had proved reasonably rewarding in my early years, though by the time Berkshire came along in 1965, I was becoming aware that the strategy was not ideal.

     If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the "cigar butt" approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the "bargain purchase" will make that puff all profit.  Unless you are a liquidator, that kind of approach to buying businesses is foolish. First, the original "bargain" price probably will not turn out to be such a steal after all.

     I could give you other personal examples of "bargain-purchase" folly but I'm sure you get the picture:  It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price. Charlie understood this early; I was a slow learner. Now, when buying companies or common stocks, we look for first-class businesses, with enduring competitive advantages, accompanied by first-class managements.

     In a difficult business, no sooner is one problem solved than another surfaces - never is there just one cockroach in the kitchen.  Second, any initial advantage you secure will be quickly eroded by the low return that the business earns. For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return.

The investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost.  Therefore, remember that time is the friend of the wonderful business, and the enemy of the mediocre.