The analytical criteria of Graham-Rao Method contain quality criteria and valuation criteria.
The quality criteria are:
1. The company must have an adequate size (Rs. 100 crore sales may be taken as adequate size for Indian companies).
2. The current assets should be at least twice that of current liabilities.
3. The total debt-equity ratio should not be greater than 1:1.
4. The company should have paid dividends for the last 10 years.
5. The company must have earned profits for the last 10 years.
6. There should be a growth in earnings per share (EPS) of 10 per cent per annum over the last seven years.
The two valuation criteria are:
1. The current price should not exceed 20 times the average EPS in the last seven years for companies with past seven-year growth higher than 20 per cent. For companies with past growth rate between 10 and 20 percent per annum, the multiplier has to be the growth rate itself. In other words fair value is the average EPS of the last seven years multiplied by the P/E ratio specified as above.
2. The current price should also not be more than 1.5 times the book value last reported.
The method requires 10-year data to analyse stocks. But the method is unambiguous and uses a limited number of ratios. Investors may complain about the 10-year data requirement; but they have to keep in mind that their hard-earned money has to be protected by committing it to companies with a good past record. Graham actually recommended dividend payment for 20 years.
12th September 2006