What is Graham’s Number in Stock?
The Graham’s number represents the fair valuation of a stock. It sets the upper price limit paid by a defensive investor for a stock. It is calculated from the Employee Earnings Per Share (EPS) and Book Value Per Share (BVPS).
Commonly known as the Benjamin Graham number, this stock valuation measure was proposed by Benjamin Graham. He is recognized as the father of “value investing.” Defensive investors use different metrics for screening, and the Graham Number is the best screener.
- Graham’s number is a method developed for the defensive investors. It evaluates a stock’s intrinsic value by calculating the square root of 22.5 times the multiplied value of the company’s EPS and BVPS.
- The formula can be represented by the square root of: 22.5 × (Earnings Per Share) × (Book Value Per Share).
- For applying this method, two conditions must be met. The Profit to Earning ratio (P/E) should be < 15. Also, the Price to Book ratio (P/B) should be < 1.5.
- This fundamental value formula does not apply to asset-light companies with more than 10% growth rate and companies with negative earnings.
How Does Graham’s Number Work?
The Graham’s number is a helpful tool for defensive investors. A defensive investor is one who is willing to invest in the stock marketStock MarketStock Market works on the basic principle of matching supply and demand through an auction process where investors are willing to pay a certain amount for an asset, and they are willing to sell off something they have at a specific price. using less time, effort, and management.
While talking about its application, this method effectively determines the maximum stock price of any company irrespective of its size and industry. Investors can find some of the best stocks at the lowest price if they employ this method. This is because the Graham number reveals undervalued stocks. Additionally, this valuation provides an opportunity to buy undervalued stocks at a lower trading price.
Graham’s Number Formula
To compute the fundamental stock value, we can use the given formula: 22.5× (Earnings Per Share) × (Book Value Per Share)
Alternatively written as 15 Earnings Per Share × 1.5 (Book Value Per Share)
Earnings Per Share (EPS) = Net Income / Shares Outstanding
Book Value Per Share (BVPS) = Shareholder’s Equity / Shares Outstanding
Now, there are certain mandatory conditions for the application of Graham Number:
- The multiple of EPSEPSEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is., 15 used in the formula, denotes the Price to Earning ratioPrice To Earning RatioThe price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. , which cannot exceed 15 in any case. This formula is inapplicable when the company’s P/E ratio is more than 15.
- Similarly, the multiple of BVPSBVPSThe book value per share (BVPS) formula evaluates the actual value of the common equity for each outstanding share, excluding the preferred stock value. A higher BVPS compared to the market value per share indicates an overvaluation of stocks and vice-versa., 1.5, signifies the Price to Book ratioPrice To Book RatioPrice to Book Value Ratio or P/B Ratio helps to identify stock opportunities in Financial companies, especially banks, and is used with other valuation tools like PE Ratio, PCF, EV/EBITDA. Price to Book Value Ratio = Price Per Share / Book Value Per Share . The P/B ratio should be below 1.5. If a company’s stocks exceed the P/B ratio limit, it cannot be computed using this stock valuation tool.
Benjamin Graham never proposed this formula directly. Instead, he outlined a stock selection criterion for the defensive investors. This parameter was published in his book, The Intelligent Investor. The analysts narrowed down upon one particular criterion, the moderate price to assets ratio. Based on that, they further developed the Graham number formula.
The moderate price to assets ratio suggests defensive investors consider the following factors before investing.
- Up to 15 times the earnings, stocks can provide better returns from assets.
- The current price of the stock shouldn’t exceed the book value multiplied by 1.5.
Example with Calculations
Consider the following numerical. Zodiac wants to buy a stock of PQR Pharma Ltd, which is trading at $14. However, he is confused if it is a good deal. The company’s net income is $1.8 million in the financial year 2020-21. Whereas the shareholder’s equity values at $240000. Additionally, 200,000 shares are outstanding. Figure out the Graham number for Zodiac.
- Net Income = $1800000
- Shareholder’s Equity = $240000
- Shares OutstandingShares OutstandingOutstanding shares are the stocks available with the company's shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner's equity in the liability side of the company's balance sheet. = 200000
Earnings Per Share = Net Income/Shares Outstanding
Earnings Per Share = 1800000/200000 = $9
Book Value Per Share = Shareholder’s Equity/Shares Outstanding
Book Value Per Share = 240000/200000 = $1.2
On applying the Graham number formula:
22.5 × (Earnings Per Share) × (Book Value Per Share)
22.5×9×1.2 = $15.59
The stock price is only $14. So, the fundamental value of $15.59 highlights that the stock is undervalued by 10.19%. Therefore, the investor should buy this stock.
Use of Graham’s Number in Value Investing
According to Benjamin Graham, the higher the investors pay for acquiring the stocks, the lower the returns. Thus, the concept of value investing is crucial for determining a fair deal whenever an investor plans to buy stocks.
Thus, this valuation metric saves the investors from paying beyond the actual value of a stock. It also helps investors discover undervalued stocks.
Some of the exceptions for using this technique in value investing are stated below:
- It is unsuitable for applying to the stocks of companies running in loss or have low earnings.
- If a company has a growth rate exceeding 10%, this technique renders an underestimated value.
- This formula determines incorrectly if the company is asset-light.
Therefore, we can say that this method is efficient in evaluating the stocks of companies with positive, tangible book value and have a growth rate below 10%.
According to Yahoo Finance, the large-cap stocks of Bank Bradesco SA, Allstate Corp, and Hartford Financial Services Group Inc. are a must-buy. In April 2021, they were undervalued, trading at a price below their Graham number.
This technique alone cannot be solely relied upon to determine the intrinsic value of stocks. To make a more sensible investment decision, the investor needs to consider the influencers behind the undervaluation as well. The alternative factors for stock value analysis include the company’s return on equityReturn On EquityReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit., revenues, profit marginProfit MarginProfit Margin can be calculated by dividing the gross profit by revenue. Profit margin formula measures the amount earned (earnings) by the company with respect to each dollar of the sales generated. , cash flow analysisCash Flow AnalysisCash flow analysis refers to examining or analyzing the company's different cash inflows and outflows during the period under consideration from the various activities, including operating activities, investing activities, and financing activities., return on capital employedReturn On Capital EmployedReturn on Capital Employed (ROCE) is a metric that analyses how effectively a company uses its capital and, as a result, indicates long-term profitability. ROCE=EBIT/Capital Employed., and debt analysis.
Frequently Asked Questions (FAQs)
Benjamin Graham is remembered as the “Father of Value Investing”. He was an influential investor and mentor for the renowned Warren Buffet. In 1949, Benjamin disclosed his value investing strategies in a book. This book was named, The Intelligent Investor.
If the Graham number is high and the stock is priced comparatively low, then the stock is undervalued. Undervalued stocks are considered a good investment opportunity. This technique evaluates the highest price a defensive investor would pay for a stock.
It has been widely applied for the last 50 years. It helped investors identify the best-priced stocks for investment. However, it seems less significant today since the recent businesses are more reliant on technology. As a result, the reliance on assets has gone down. Nonetheless, for asset bases companies, this technique still holds true. Since technology will not replace all businesses, the relevance of the technique will continue.
This article has been a guide to Graham’s Number & its Definition. Here we discuss the formula to calculate the stock value along with examples. You can learn more about from the following articles –