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A.4.1 Fundamental Analysis & Screening from Zero

Basic Prerequisites: Core Financial Ratios (a P/E and a current ratio, nothing more). No prior screening knowledge needed.

1. Intuition & Practical Objective

This page builds the why of fundamental investing with no prior knowledge needed. The objective is a single chain of reasoning: a stock is a piece of a business; a business has an intrinsic value; the market price is not that value; and the gap between price and value is where money is made or lost.

Start with the dumbest question: what does owning a stock actually mean? It means you own a fraction of a real company - its factories, its customers, its earnings. If the company earns money, you eventually get some of it. So a stock is not a lottery ticket; it is a claim on a business. That sounds trivially obvious and it is the entire discipline. Everything else is method.

Three steps:

  1. Price and value are two different things. The market quotes a price every second; that price moves on fear, fashion, and flows. The value of the business moves on earnings, assets, and prospects. Benjamin Graham personified the price as “Mr. Market,” a manic-depressive business partner who offers to buy or sell at a different price every day - and whom you are free to ignore. When Mr. Market’s price is below your estimate of value, you buy; when it is above, you sell or wait. His mood is an opportunity, not an instruction.

  2. The margin of safety is the whole game. You will be wrong sometimes. Graham’s answer is not to be right more often - it is to buy cheap enough that being wrong doesn’t ruin you. If a business is worth roughly $40 a share and you buy at $60, you need everything to go right; buy at $27 and you can be substantially wrong and still not lose money. The gap is the margin of safety, and it is the single most important idea in this entire folder. The Graham Number you will compute below is one concrete expression of it.

  3. Screening is how you make the search possible. There are thousands of listed companies. You cannot read every annual report. So you screen: apply a few mechanical filters (cheap enough, safe enough, stable enough) to shrink the universe to a handful of names, then do the human work of reading their filings. The screen is not the analysis - it is the triage that tells you where to spend your reading time. (This is the workflow that 04 · The Research Workflow makes concrete.)

2. Mathematical Ground Truth & Derivations

Value from a price and an earnings stream - the two ratios that started it all. The two cheapest definitions of “am I paying too much?” are:

where is the price, earnings per share, and book value (net assets) per share. A P/E of 10 means you pay $10 for every $1 of annual earnings - a rough “payback period” of ten years. A P/B of 1 means you pay $1 for every $1 of accounting net worth.

Graham’s two price ceilings, combined. Graham’s defensive rule caps the multiple of earnings at 15 and the multiple of book at 1.5. Multiply the two inequalities and a single price ceiling falls out:

so the highest price consistent with both caps - the Graham Number - is

This is the mathematical heart of the page: a price ceiling derived from two independent fundamental anchors, so that a stock is not “cheap on earnings but expensive on assets” - it must satisfy both.

Margin of safety. If is your estimate of value (here, the Graham Number), require buying only at a discount:

Graham’s aggressive version is buying at two-thirds of value - sometimes stated as requiring value price.

3. Computational Implementation - price vs. value for one company, from zero

Runs on the standard library only. It takes one company (Alpha Machine Works: 3-yr average EPS $2.60, book value per share $22.00, price $30.00) and computes the value ceiling, the margin of safety, and the buy/watch verdict - the whole discipline in eight lines.

Read the output as a decision, not a calculation: at $30 the stock trades at a 16.4% discount to its Graham Number - a positive but thin margin of safety. Under Graham’s aggressive “buy at two-thirds” rule the verdict is watch, not buy. That gap between “cheap-ish” and “cheap enough” is the discipline: the number does not tell you the stock is bad, it tells you the cushion is too small to protect you if you are wrong. (The same logic, extended across a universe, is the screen in the hub and the richer metrics in 03 · Screening Metrics.)

4. Failure Modes & First-Principles Breakdowns

  1. Confusing cheap with good. A low P/E can mean “the market hasn’t noticed” or “the market has correctly noticed the business is dying.” The Graham Number cannot tell you which - only the business reading can. This is the value trap, and it is the whole thesis of 05 · Failure Modes.
  2. Book value is an accounting number, not a floor. On a modern firm whose assets are intangible (software, brands, people), understates true net worth; on a declining manufacturer with obsolete plant, it overstates it. The Graham Number inherits every weakness of the book value that feeds it.
  3. A margin of safety on the wrong value estimate is no safety at all. If your is anchored to a growth assumption that is too optimistic, a “30% discount” is a discount to a fantasy. The margin of safety is only as real as the value estimate under it - which is why the estimate must be grounded in the actual filings.

5. References

  • Graham, Benjamin: The Intelligent Investor (rev. 1973; HarperBusiness annotated 4th ed. 2003)
  • Graham, Benjamin & Dodd, David: Security Analysis (McGraw-Hill, 6th ed. 2008)
  • Greenwald, Kahn, Sonkin & van Biema: Value Investing: From Graham to Buffett and Beyond (Wiley, 2001)
  • Dorsey, Pat (Morningstar): The Five Rules for Successful Stock Investing (2004)

6. Connected Graph Bridges

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