What is the Graham Number

The Graham Number is a formula used to determine the intrinsic value of a stock, specifically to assess whether a stock is undervalued or overvalued. It was introduced by Benjamin Graham, a renowned investor and the author of the book "The Intelligent Investor." The formula is a simple way to estimate a company's fair value, primarily focusing on its earnings and book value.

The Graham Number is widely used by value investors to identify stocks that are trading below their intrinsic value, offering potential investment opportunities. It combines two key metrics: the price-to-earnings (P/E) ratio and the price-to-book (P/B) ratio, both of which help investors assess a company’s financial health and profitability.

How to Calculate the Graham Number

The formula for the Graham Number is:

Graham Number = √(22.5 × Earnings Per Share (EPS) × Book Value Per Share (BVPS))

This formula considers a company’s earnings and book value per share, which are both crucial indicators of its financial strength. The number 22.5 is a constant that was derived by Graham, representing the maximum P/E ratio of 15 and the maximum P/B ratio of 1.5, which he believed was reasonable for valuing stocks.

Example of the Graham Number

Let’s say a company has an earnings per share (EPS) of $5 and a book value per share (BVPS) of $40. To calculate the Graham Number, you would plug these values into the formula:

Graham Number = √(22.5 × 5 × 40) = √(4500) ≈ 67.08

In this case, the Graham Number for this stock would be approximately $67.08. If the stock is trading below this value, it could be considered undervalued according to Graham's formula, indicating a potential investment opportunity for value investors.

Why Use the Graham Number

The Graham Number is a valuable tool for investors looking for undervalued stocks with strong fundamentals. It helps investors avoid overpaying for stocks by setting a benchmark for what the intrinsic value should be based on the company’s earnings and book value. By comparing the Graham Number with a stock’s current market price, investors can quickly identify potential bargains.

This formula is especially useful for value investors, as it helps them make more informed decisions when analyzing stocks. It provides a margin of safety, which is a central concept in value investing. A stock trading significantly below its Graham Number may offer a good entry point for long-term investment.

Interpreting the Graham Number

Interpreting the Graham Number involves comparing the calculated value with the stock's current market price. If the stock price is significantly lower than the Graham Number, it may indicate that the stock is undervalued and could present a good investment opportunity. Conversely, if the stock price is higher than the Graham Number, it could suggest that the stock is overvalued and may not be a wise investment at that time.

However, the Graham Number is not an infallible tool. While it provides a useful estimate of intrinsic value, it doesn't account for factors such as future growth potential, market sentiment, or industry trends. Therefore, investors should use the Graham Number in conjunction with other financial metrics and analysis methods for a more comprehensive evaluation of a stock.

Practical Applications of the Graham Number

The Graham Number is primarily used by value investors to screen for stocks that are trading below their intrinsic value. It can be applied across a wide range of industries, especially in situations where companies have stable earnings and a solid book value. For example, a company with a low P/E ratio and high book value might be considered a good candidate for value investment if its market price is below the Graham Number.

This formula is also useful in comparing companies within the same industry. If two companies have similar earnings and book values, the one with the lower market price relative to its Graham Number might present a more attractive investment opportunity. Additionally, the Graham Number can be used to assess the relative safety of a stock before committing to an investment.

Conclusion

The Graham Number is an essential tool for value investors who aim to identify undervalued stocks with strong fundamentals. By calculating the intrinsic value of a stock using its earnings and book value, the Graham Number helps investors assess whether a stock is trading below its fair value. This formula offers a margin of safety, which is critical in minimizing investment risk.

While the Graham Number provides valuable insight, it should not be used in isolation. Investors should consider other financial ratios and perform comprehensive due diligence to make informed investment decisions. Overall, the Graham Number remains a key formula in value investing, offering a straightforward way to evaluate a stock’s potential for long-term growth.