Have you asked yourself if the stock you are looking to buy is too expensive? or too pricey? or overvalued?
No one wants to pay more than they should and every investors regularly ask themselves the question.
This is where stock valuation comes into play to identify if a stock is undervalued.
In fact, value investors often refer to Benjamin Graham as the father of value investing for his valuation formula aptly named the Graham Number.
In the short run, the market is a voting machine but in the long run, it is a weighing machine.
What is the Graham Number?
The Graham Number is defined as the maximum price an investor should pay for a stock. If a stock is available at a price below the Graham Number, it is considered undervalued.
However, if the price is above Graham Number, it should be avoided. Graham Number is considered an important metric for value investing and for defensive investors.
The Graham Number Formula
This formula is named after Benjamin Graham who is regarded as the father of Value Investing. The formula used to calculate the Graham Number is:
Value = The square root of (22.5 * EPS * BVPS).
- EPS = The earnings per share. The EPS is calculated by dividing the company’s net profit by the number of shares. It’s an easily accessible metric.
- BVPS = The book value per share is the total equity divided by the outstanding number of shares.
The 22.5 factor is included as Ben Graham believed that PE and PB values should not be over 15x and 1.5x, respectively. It’s arrived as the product of his maximum PE of 15 and maximum PB value of 1.5.
Graham put emphasis on certain criteria to consider before investing in a stock. These are:
- the size of the company,
- strong financials,
- positive and growing earnings,
- stable dividend payments,
- moderate PE, and
- low PB value.
These factors offer a good combination of both qualitative and quantitative analysis.
How to use the Graham Number today?
The Graham Number might not work universally for all companies in today’s times.
The formula came into being at a time when there was no concept of asset-light and SaaS companies. Today companies are turning asset-lighter and are more technology-intensive.
The Graham Number, as originally defined, focuses on companies which were asset-heavy such as banks, industrials, defence companies, etc. Companies with stable earnings and less volatility are better fit for the Graham Number screening.
Hence, it might not be the go-to screening metric today for some companies. From a business life cycle perspective, companies in the established and maturity state are a better fit.
- Start-up: A new launching new products or services. Rarely do they trade on the stock market. Still proving themselves ahead of an IPO.
- Growth: Successful launch and growing. Usually with rapid sales growth. Looking at an IPO and turning a profit.
- Established: Sales are slowing down from competition or saturation.
- Maturity: Sales are normalizing and profit margins are getting thinner.
- Expension/Decline: This is an adapt or fail turning point. Larger companies will have products go through the cycle internally at faster rate.
A word of caution, even if a stock stands undervalued based on the Graham Number, you must not blindly initiate the trade. Instead try and find the reason for undervaluation. You must be careful that these undervalued stocks are not beaten down to avoid capital losses.
The Graham Number can be used as a starting guide to screen expensive stocks for value investors but cannot be fully relied upon.
The Price to Graham Number Ratio
It’s not enough today to just compare the company’s stock price to the Graham Number as it ignores the industry’s strengths or weaknesses.
To that extent, it’s much better to use the Price to Graham Number Ratio and put it into perspective within an industry.
Take the Canadian insurance industry, you can use the Price to Graham Number Ratio to see how it fares as an industry and the relative valuation.
A ratio of 1.0 means it’s perfectly valued while over is overvalued and under is considered undervalued.
Where to get the Graham Number?
If you like the idea of using the Graham Number, you will either need to calculate it yourself if you can find the Book Value Per Share somewhere, otherwise, some screeners have it ready to use as shown above.
It’s one thing to know how to calculate it and how to use it, it’s another to insert the number in your filtering and decision process. Save yourself time with a screener.
Pros of Graham Number
- Easy to use and calculate – Graham Number is easy to use and understand and can be used as a shortcut for a quick estimate of value.
- Upper price limit – A good indication of the upper limit of price that can be paid by a value investor. It is an important ratio for investors looking for significant long term returns by investing conservatively.
- Suitable for strong defensive businesses – Works best for defensive companies having a dependable business model and steady earnings such as banking, insurance, or industrial.
Cons of Graham Number
- More focused on technical indicators – While the number takes into account various financial metrics like PE, PB, EPS, BV, etc., it completely avoids the other fundamental metrics like management quality, industry and competition. People might still want to buy a company like Apple, Google, Microsoft, etc. even though ruled out by Graham Number, driven by other reasons like market position, competitive landscape, future growth prospects, etc.
- A company must have positive EPS and BV metrics – Only works for companies having positive EPS and Book value. Theoretically, a stock priced below the Graham Number would be considered a good value, if it also meets the other criteria provided by Graham. Graham Number along with these criteria provides a good starting point for screening stocks further or doing more research.
- Conservative approach – The Graham Number does not account for growth in its calculations. Hence, it does not work well for growth companies and companies having less tangible assets like software and service companies.
Should you use the Graham Number?
The Graham Number is still a powerful tool to analyze insurance companies, banks, and other businesses.
Though Graham Number is an easy way to value a stock, there might be a constant debate in investors’ minds on Growth vs. Value. The final choice of ratios will depend on one’s investment strategy. It is, therefore, better to consider a combination of Graham Number and other financial ratios to make any investment decision.
How Dividend Earner Uses The Price to Graham Number Ratio
While I don’t pay strict attention to the stock price valuation as generated by the Graham Number, I do like to see how the Price to Graham Number compares to the competitors in the industry.
Frequently Asked Questions
How to use Graham Number to value a stock?
Graham Number is the maximum price an investor should pay for a stock. Any value that is below this number makes suitable investment candidates solely based on this number. However, investors are advised to do further research as Graham Number is a quantitative metric.
Is Graham Number the best way to find undervalued stocks?
Graham Number is convenient to use and easy to calculate. Its formula focuses only on PE and PB values. It does not consider other important aspects like growth, cash generation, competitive landscape, management quality, etc. However, these are important factors to be considered before making any investments.
Is Graham Number still relevant?
The Graham Number might not be as relevant today as it was five decades ago when invented as the companies are becoming less capital intensive and more focused on rendering services.