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* = 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* = 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.
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.
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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.