The Graham Number: An Investor’s Guide to Value Stocks
The Graham number, named after the pioneering investor Benjamin Graham, is a key measure for assessing a stock’s intrinsic value by incorporating the company’s earnings per share (EPS) and book value per share (BVPS). It’s seen as the maximum price that a cautious investor should pay for a stock, implying that prices below this threshold indicate an undervalued stock, ripe for investment.
Key Insights:
- Optimal Pricing: The Graham number helps determine the highest price an investor should pay for a stock according to Graham’s value investing principles.
- Heritage: Originated by Benjamin Graham, the father of value investing.
- Calculation Method: Calculated using a company’s earnings and book value per share, with a modifier of 22.5, which represents an ideal P/E ratio capped at 15x and a price-to-book ratio capped at 1.5x.
Delving into the Graham Number’s Calculation
The Graham number serves as a general filter for identifying underpriced stocks. Based on the belief that a P/E ratio should be no more than 15x and a price-to-book ratio no more than 1.5x, the calculation employs a constant factor of 22.5. Here’s how you can calculate it:
Graham Number = sqrt(22.5 × EPS × BVPS)
Alternatively, it can be illustrated through:
= sqrt(15 × 1.5 × (Net Income / Shares Outstanding) × (Shareholders' Equity / Shares Outstanding))
Specific Components Defined:
- Earnings Per Share (EPS): This is calculated as the company’s net profit divided by the number of outstanding shares of common stock.
- Book Value Per Share (BVPS): This is obtained by dividing equity available to common shareholders by the number of outstanding shares.
Using these variables, the Graham number aims to balance a fair multiple of earnings with a stable book value, analogously moderating at a product of 22.5 = 15 (P/E) x 1.5 (P/B).
Practical Example:
To illustrate, assume company XYZ has an EPS of $1.50 and a BVPS of $10. The calculated Graham number would be:
sqrt(22.5 × 1.5 × 10) = $18.37
Thus, $18.37 is the ceiling price under Graham’s valuation principles. If the stock trades below this, say at $16, it’s considered attractive; if it’s at $19, it’s seen as overvalued.
Limitations of the Graham Number
Though useful, the Graham number doesn’t factor in several essential elements like the quality of management, industry dynamics, or competitive landscape. Fundamental analysis, valued by Graham and mentees like Warren Buffett, often looks beyond core financial figures to include Bill fundamental characteristics such as ROE, profit margins, and market position.
Implementing Graham’s insights
For value investors, any stock priced below its Graham number serves as an appealing buy. The stance ensures a margin of safety, combining EPS and BVPS under acceptable multiples.
About Benjamin Graham
Benjamin Graham is celebrated for developing value investing — a strategy focused on financial statement analysis to identify undervalued stocks. His teachings influenced many, notably Warren Buffett. His book, The Interpretation of Financial Statements, remains a cornerstone in value investing.
Conclusion
The Graham number is critical in value investing by establishing the maximum fair price for stocks based on EPS and BVPS. Stocks priced lower than the Graham number highlight potential investment opportunities, adhering to Graham’s principles of prudence and fundamental value.
Related Terms: earnings per share, book value per share, price-to-earnings ratio, price-to-book ratio, value investing.
