Want to build a safe FIRE portfolio? Learn Benjamin Graham’s simple 22.5 rule to filter out dangerous stocks, and discover why you shouldn’t trust it blindly.
Introduction: Where Do We Start?
We all want to build a strong passive income pipeline, quit our boring jobs, and travel the world. To do that, we need to buy good assets and hold them for the long term.
But when you open your stock brokerage app, there are thousands of companies blinking in red and green. How do you even begin to filter out the garbage and find the safe stocks?
Benjamin Graham, the legendary investor and the man who taught Warren Buffett, knew that average investors get easily confused by complex math. So, he created a very simple, 5-second mathematical filter to protect us from buying dangerously overpriced stocks. It is called the “Rule of 22.5.”
Today, we are going to learn how to use this quick filter. But more importantly, we will learn why you cannot blindly trust this rule for every stock.
The Rule of 22.5: The Simple Metal Detector
Benjamin Graham believed in the Margin of Safety To him, the biggest risk was paying too much for a stock. To avoid overpaying, he told defensive investors to look at two simple numbers you can find on any finance website like Yahoo Finance:
- P/E Ratio (Price-to-Earnings): How much you are paying for $1 of the company’s profit. Graham said a safe stock should have a P/E below 15.
- P/B Ratio (Price-to-Book): How much you are paying for the physical assets of the company. Graham said this should be below 1.5.
Here is his simple math: If you multiply the P/E ratio by the P/B ratio, the result should not be higher than 22.5 (15 x 1.5 = 22.5).
- For example: If a company has a P/E of 10 and a P/B of 2, the product is 20. It passes the test!
This rule is like a metal detector on the beach. It quickly scans the sand and beeps to tell you, “Hey, this stock is not ridiculously expensive right now!”
The Hidden Trap: Why You Can’t Use It for Everything
Now, here is where many beginners make a huge mistake. They think the Rule of 22.5 is an absolute truth. They find a stock with a score of 18, scream “It’s a bargain!”, and put all their money into it.
Stop right there.
The Rule of 22.5 is just a rough filter, not a magic wand. There is a massive limitation to this rule that you must understand: Every industry has a completely different average P/E ratio.
You cannot apply the same 22.5 standard to a software company and a steel factory. Here is why:
- Asset-Heavy vs. Asset-Light: A traditional manufacturing company (like a car maker) needs giant, expensive factories. Their Book Value (P/B) is naturally high, so their P/E is usually low. But a modern tech company (like a software developer) only needs laptops and smart brains. They have very few physical assets, so their P/B will naturally be huge, making their score easily blow past 22.5.
- The Trap of a “Low” P/E: Sometimes, a stock has a very low P/E ratio because the business is dying. The market already knows the company’s profits will crash next year, so the price is cheap today. This is called a “Value Trap.”
If you apply Graham’s rule blindly to every stock, you will end up buying only old, dying, or boring companies, and you will miss out on great modern businesses.
Conclusion: What is the Next Step?
So, how should we use Graham’s rule today? Use it as a “Danger Alarm.” If a traditional company has a score of 100 or 200, you instantly know it is wildly overpriced and you should walk away. It is a tool to eliminate bad choices, not a tool to confirm a good choice.
But once you filter out the overpriced garbage, how do you know what a company is actually worth? How do you know if it is a truly great business?
That is where Graham’s student, Warren Buffett, changed the game. Buffett realized that picking stocks isn’t just about finding the “cheapest” numbers. It is about calculating the true intrinsic value of a business and waiting until the price makes sense.
In our next post, we will throw away the simple P/E ratios and learn exactly how Warren Buffett calculates the true value of a business using something called “Owner Earnings.” Stay tuned!