How to Find Bargain Picks: The Graham Formula

Knowing how to properly value a stock and find a bargain pick is probably the most important skill for a value investor to develop.

The goal is to buy companies for less than their intrinsic value over a long period of time. This will almost certainly result in sustainable investment returns in one’s brokerage account.

Over the last fifty years one of the most popular methods to discover the fair price of a stock has been the Benjamin Graham formula.

Named after the father of value investing himself, the Graham Formula is an intrinsic value model used to quickly determine how rationally priced a particular stock is. As with most valuation methods, this formula is not designed to give a true value of a stock. Instead, it only gives an approximation of the value. The original formula as described by Graham in 1962 looks like the following.

V*=EPS\times (8.5+2g)

V* = Intrinsic value
EPS = Trailing twelve months earnings/share
8.5 = P/E base for a no-growth company
g = reasonably expected 7 to 10 year growth rate

As you can see it is not a very complicated formula. In his book, The Intelligent Investor, Benjamin Graham disregarded complicated calculations and kept his formula simple. In his words: “Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the evaluation of growth stocks. This is intended to produce figures fairly close to those resulting from the more refined mathematical calculations.”

However, this formula doesn’t account for macro economic factors and changes to the economy over time. All intrinsic value calculations and formulas are based on the opportunity cost relative to the risk-free interest rate. This interest rate is not a static variable. So in the interest of making more accurate approximations, Benjamin Graham revised his formula in 1974 to the following.

V*={\cfrac {EPS\times (8.5+2g)\times 4.4}{Y}}

V* = Intrinsic value
EPS = Trailing twelve months earnings/share
8.5 = P/E base for a no-growth company
g = Expected long term earnings growth rate
4.4 = Average yield of high-grade corporate bonds in 1962, when the formula was introduced
Y = Current average yield on 20 year AAA corporate bonds

This updated formula accounts for the difference between the bond rates in 1962, when the model was first introduced, and today’s rates.

(credit to Wikipedia for the formula figures)

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The Graham Formula in Practice

Let’s use the formula to calculate the intrinsic value of AT&T Inc., a well known communications and digital entertainment company. First we find out the necessary information about the stock (NYSE:T)

EPS = 2.35. This information can be found on Yahoo Finance or other stock sites.
g = 4.80%. This information is available on Nasdaq’s site. Y = 3.59. This number can be found in the Corporate bond table of Yahoo’s site.