TL;DR: Deep value screening means filtering shares on numbers that point to a low price relative to earnings and assets, such as a low price/earnings ratio and a low price relative to book value. You only buy with a margin of safety and spread across many shares. It offers no certainty.
What can you expect?
- Time per week
- About 2 to 4 hours a week in the early phase (filtering and reading annual reports), less later.
- Starting capital
- No fixed minimum, but a diversified portfolio of dozens of shares needs a sizeable amount. With small amounts, fixed order costs weigh heavily. Only invest money you can afford to lose.
- Typical setbacks
- Shares that stay cheap or fall further, companies that go bankrupt, and years in which you lag the market.
- Costs
- Order costs, spread (large for small companies), currency costs on foreign shares, custody fees from the broker and withholding tax on dividends. Compare the costs of several brokers.
- Not suitable if…
- People who want quick results, do not want to read annual reports or cannot bear losses on individual positions.
How it works
In The Intelligent Investor (1949) and Security Analysis (1934, with David Dodd), Benjamin Graham described how to select shares using numbers: a low price/earnings (P/E) ratio, a low price relative to book value, a sound balance sheet and a margin of safety between price and estimated value. The criteria below are a simplified version, not literal rules. A share that passes such a filter is not automatically a good investment: the price can stay low for years (a 'value trap') and you can lose your investment. This is education, not investment advice.
Core principles
- 1. Filter on numbers rather than stories
- 2. Only buy with a margin of safety between price and estimated value
- 3. Spread across many shares, because some picks will disappoint
- 4. Give the market time: value recovery can take years or never come
Step-by- step plan
- 1
Set up your filter
In a screener, build a filter with simplified Graham criteria: low P/E, low price-to-book, current assets at least twice current liabilities and debt below equity. Start with markets you know where shares trade well.
- 2
Estimate the value
Estimate a value for each candidate, for example from net current assets or a cautious estimate of earnings and growth. Graham gave a simplified formula for growth shares, but did not treat it as certainty himself. Only buy when the price is well below your estimate.
- 3
Check the balance sheet and the trend
Read the balance sheet and income statement over at least three years. Are receivables growing faster than sales? Is inventory building up? Is cash falling? A low price is worth little if the balance sheet is deteriorating.
- 4
Diversify and set position size
Spread your money over many shares and keep each position small. Some picks will disappoint. Diversification reduces the effect of a single miss but does raise your costs.
- 5
Set your sell rules in advance
Decide in advance when you sell: at your value estimate, when the numbers deteriorate or when the price has not recovered after a set period. Review your positions at fixed moments and try not to trade too much.
In detail
Mr. Market and the margin of safety
Graham used an image: Mr. Market is your business partner with changing moods. Every day he offers to sell you his share or buy yours. Sometimes his price is too high, sometimes too low. You are never obliged to accept his offer.
The margin of safety is the gap between your estimate of value and the price. If you estimate value at €100 and only buy at €70, you have room for errors in your estimate. It is a buffer, not a guarantee: the estimate itself can also be wrong.
The numbers you filter on
Graham looked for shares with a low price relative to earnings (P/E) and book value, a solid balance sheet and little debt. For the 'defensive investor' he names, among other things, a P/E below about 15 (on average earnings over several years), a price/book below about 1.5 and current assets of at least twice current liabilities. The limits above are a simplification.
A low P/E can also mean earnings are temporarily high or about to fall. So you read annual reports over several years and look at the trend.
Net-nets: an extreme variant
A 'net-net' is a share whose price is below net current asset value per share (current assets minus all liabilities). Graham named a price of at most two thirds of that value. Such companies are rare and often small and hard to trade. The example below works through a net-net with made-up figures.
Why it is hard
Stock markets in large developed countries are closely followed by analysts, so genuinely cheap shares with a healthy balance sheet are rare. What passes a filter is often cheap for a reason: falling sales, high debt or poor management. A large part of the work is therefore finding out which shares are 'value traps'.
The method also needs patience. It can take years before the market values a share differently, and it may never happen.
- Basic knowledge of financial statements
- Patience for a horizon of several years
- Stock screener
- Annual reports and financial statements
- Spreadsheet for your value estimate
- 01 Price/earnings (P/E) below about 15, based on average earnings over several years
- 02 Price-to-book below about 1.5
- 03 Current assets at least twice current liabilities
- 04 Debt no higher than equity
- 05 Price well below your own value estimate (for example a 30% margin)
- 01 Sell when the price reaches your value estimate
- 02 Sell or review when the numbers deteriorate
- 03 Review the position if the price has not recovered after a few years
- 04 Only reinvest proceeds in new candidates that pass your filter
Worked example
Made-up worked example (not advice, not a forecast). A small company has, according to its balance sheet: current assets €60 million, total liabilities €25 million and 5 million shares. The share price is €4.20.
Formula: net current asset value per share (NCAV) = (current assets − total liabilities) / number of shares.
- NCAV = (€60,000,000 − €25,000,000) / 5,000,000 = €7.00 per share
- Graham limit: two thirds of NCAV = €7.00 × 2/3 = €4.67
- A price of €4.20 is below €4.67. The share meets this criterion.
- Margin of safety: (€7.00 − €4.20) / €7.00 = 40%
This says nothing yet about the quality of the company. Can the current assets really be turned into cash (inventory, receivables)? Is the company losing money? Then NCAV can fall quickly. At a price of €6.00 the margin would be only 14% and the share would not meet the limit. Order costs and spread on a small company come on top.
Hypothetical example, not advice.
Work it out yourself
Risks and risk management
- Value trap: a share is cheap because the company really is doing badly
- You can lose your entire investment in one share
- Lagging the market for a long time is possible
- Figures from annual reports are out of date and can be misread or manipulated
- Small companies are hard to trade: spread and the impact of your order can be large
- Spreading across many shares raises the cost per euro invested
- Limit any one position to a small part of your portfolio and accept that some picks will fail
Learn the basics
Key takeaways
- Graham saw the stock market as a partner with changing moods ('Mr. Market'): you never have to accept his price.
- The margin of safety is meant for errors in your estimate. It gives no certainty of profit.
- A numbers filter finds candidates, not guarantees. Always read the annual report.
- Value traps exist. Diversification and small position sizes limit the damage from a single miss.
Frequently asked questions
Does deep value screening still work? +
That is not certain. In large, closely followed markets, shares that meet strict criteria are scarce. In smaller markets you meet them more often, but they are harder to trade. A cheap share can stay cheap. Past results say nothing about the future.
How much patience does this approach need? +
Expect several years per position. It can take a long time before the market values a share differently, and it may not happen. So decide in advance after what period you review a position.
How do I find shares that meet these criteria? +
Many brokers and financial websites have a screener that lets you filter on P/E, price-to-book and debt ratios. Compare more than one data source and always read the annual report yourself. Take order costs, spread, currency costs and withholding tax on dividends into account.
Origin
Devised by / based on: Benjamin Graham . Source: The Intelligent Investor (1949) en Security Analysis (Graham & Dodd, 1934)