Benjamin Graham formula

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The Benjamin Graham formula is an intrinsic value formula proposed by investor and professor, Benjamin Graham, often referred to as the "father of value investing". Published in his book, The Intelligent Investor, Graham devised the formula for investors to be able to quickly determine how rationally priced their stocks were.[1] As with any valuation formula, the final number is not designed to give a true value of a stock, but only to approximate its range of possible values.[citation needed]

Formula calculation[edit]

In The Intelligent Investor, Benjamin Graham describes a formula he used to value stocks. He 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, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations."

The formula as described by Graham in the 1962 edition of Security Analysis, is as follows:

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

V = Intrinsic Value
EPS = Trailing Twelve Months Earnings Per Share
8.5 = P/E base for a no-growth company
g = reasonably expected 7 to 10 year growth rate

Where the expected annual growth rate "should be that expected over the next seven to ten years." Graham’s formula took no account of prevailing interest rates.

Revised formula[edit]

He revised his formula in 1974 (Benjamin Graham, "The Decade 1965-1974: Its significance for Financial Analysts," The Renaissance of Value) as follows:

Graham suggested a straight forward practical tool for evaluating a stock's intrinsic value. His model represents a down-to-earth valuation approach that focuses on the key market-related and company-specific variables.

The Graham formula proposes to calculate a company’s intrinsic value V* as:

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

V: Intrinsic Value
EPS: the company’s last 12-month earnings per share
8.5: the constant represents the appropriate P-E ratio for a no-growth company as proposed by Graham
g: the company’s long-term (five years) earnings growth estimate
4.4: the average yield of high-grade corporate bonds in 1962, when this model was introduced [2]
Y: the current yield on 20 year AAA corporate bonds.[3]

Application[edit]

To apply this approach to a buy-sell decision, each company’s relative Graham value (RGV) can be determined by dividing the stock’s intrinsic value V* by its current price P:

RGV = \cfrac{V*}{P}

An RGV of less than one indicates an overvalued stock and should not be bought, while an RGV of greater than one indicates an undervalued stock and should be bought.

Because of the measures it uses, difficulties may be encountered in evaluating both new and small company stocks using this model as well as any stock with inconsistent EPS growth. On one hand, it is efficient because of its simplicity but on the other, it is limited by its simplicity because the model does not work well for every stock.

Thus, the calculation is subjective when considered on its own. It should never be used in isolation; the investor must take into account other factors such as:

  • Net Current Asset Value in order to determine the financial viability of the firm in question
  • Current Asset Value in order to determine short-term financial viability of the firm
  • Debt to equity ratio
  • Quality of the Current Assets.

The Misunderstood Formula[edit]

This formula was never intended to be used as a predictive measure and any reliance on this formula is contrary to Graham's intent in including it in his book. He wrote, "Warning: This material is supplied for illustrative purposes only, and because of the inescapable necessity in security analysis to project the future growth rate for most companies studied. Let the reader not be misled into thinking that such projections have any high degree of reliability or, conversely, that future prices can be counted on to behave accordingly as the prophecies are realized, surpassed, or disappointed." In the original book "Value Investing," Graham included a disclaimer stating that the formula was not to be used for establishing value, only to be analogous with other, more complex, formulas. This confusion stems from armchair analyst's ignorance. Don't use this formula. [4]

References[edit]

External links[edit]