The fact that the “Y” variable, which is the corporate bond yield today, is lower than the 4.4 numerator rate suggests that stocks in general are more expensive today than in the past. Once we have the required variables we can plug them into the formula. This will give us the intrinsic value for Wal-Mart.
IV = 2.35 x (8.5 + 2 x 4.8) x 4.4 / 3.59
IV = $52.13
Using the formula we can see that AT&T has an intrinsic value of about $52. The actual price of the stock is about $41 today. We can compare the two numbers to determine some conclusions about the stock. In this particular case, since the intrinsic value is higher than the actual price per share, it is likely that AT&T is considered undervalued by this metric.
However, if the calculated intrinsic value of a stock is lower than its share price, then it should be considered overvalued. Since the nature of a stock’s valuation is to revert back to the mean over time, we should try to buy undervalued stocks and avoid overvalued ones.
Drawbacks and Risks
The Graham Formula is a useful tool to derive a quick approximation of the true value of a stock so investors can make informed decisions about their purchases. But it’s not a perfect model. The formula doesn’t account for human judgement and global trends. For example, a horse drawn carriage company one hundred years ago would have been really undervalued based on the Graham’s formula.
But many investors who understood that automobiles would eventually take over the roads would not have invested in the company. Its future financial outlook looked grim. It’s not wise to rely on a stock valuation model without critically thinking about the implications behind the figures.
That is why some traditional brick and mortar companies such as Best Buy (NYSE:BBY) are trading at extreme discounts compared to their Graham formula’s intrinsic values. Although BBY is cheaply valued, many investors choose to avoid the stock. They’re worried it will continue to lose market share to online retailers such as Amazon.com in the long run.
Another problem is that for some smaller companies, the long term expected growth rate may not be readily found on the internet. In this case, using the previous year’s average earnings growth rate would be an appropriate substitution for the “g” variable.
Related: Why You Should Incorporate China ETF Exposure
Customizing the Graham Formula
For more experienced investors, the formula can be adjusted to suit a more targeted investment strategy. For example, if the calculation of “2 x g” is too aggressive, then you can drop the multiplier down to 1.5. Furthermore, the 8.5 number that represents the base P/E ratio can be adjusted based on your level of risk tolerance and conservatives. Anything within the rage between 7 to 9 would be appropriate. Using a more selective approach for finding only the most undervalued stocks, we can alter the formula for AT&T to the following.
V = 2.35 x (8.5 7.0 + 2 1.5 x 4.8) x 4.4 / 3.59
V = $40.90
By using a more strict valuation method we
can create a larger margin of safety to make better investment choices. We just have to remember to apply a consistent model to all the value stocks in our portfolio.
By using the Graham formula investors will have an increased probability to avoid bubbles similar to the dot-com crash. It’s not a complete tool. But the Graham formula is a very useful preliminary screener for potential stocks that might be worth taking a closer look at.
This article has been republished with permission from Modest Money.