Benjamin Graham formula: Difference between revisions
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The ''' Benjamin Graham formula''' is |
The ''' Benjamin Graham formula''' is a formula proposed by investor and professor of Columbia University, [[Benjamin Graham]], often referred to as the "father of value investing"<ref>{{Cite book|title=Benjamin Graham: The Father of Value Investing|last=Dave|first=John|publisher=CreateSpace Independent Publishing Platform)|year=2014|isbn=1500653748}}</ref>. Published in his book, ''[[The Intelligent Investor]]'', Graham devised the formula for lay investors to help them model growth formulas in vogue at the time of the formula's publication.<ref name=":0">{{Cite book|title=The Intelligent Investor: Revised Edition|last=Graham|first=Benjamin|publisher=First Collins Business Essentials|year=2006|isbn=0-06-055566-1|location=|pages=295, 585}}</ref> |
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==Formula calculation== |
==Formula calculation== |
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In ' |
In Graham's 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." |
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The formula as described by Graham in the 1962 edition of ''[[Security Analysis (book)|Security Analysis]]'', is as follows: |
The formula as described by Graham in the 1962 edition of ''[[Security Analysis (book)|Security Analysis]]'', is as follows: |
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:<math>V* = EPS \times (8.5 + 2g) </math> |
:<math>V* = EPS \times (8.5 + 2g) </math> |
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V = The value expected from the growth formulas over the next 7 to 10 years<BR> |
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V = Intrinsic Value<BR> |
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EPS = Trailing Twelve Months Earnings Per Share<BR> |
EPS = Trailing Twelve Months Earnings Per Share<BR> |
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8.5 = P/E base for a no-growth company<BR> |
8.5 = P/E base for a no-growth company<BR> |
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g = reasonably expected 7 to 10 year growth rate |
g = reasonably expected 7 to 10 year growth rate |
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Where the expected annual [[economic growth|growth rate]] "should be that expected over the next seven to ten years." Graham’s formula took no account of prevailing [[interest rate]]s. |
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===Revised formula === |
===Revised formula === |
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:<math>V* = \cfrac{EPS \times (8.5 + 2g) \times 4.4}{Y}</math> |
:<math>V* = \cfrac{EPS \times (8.5 + 2g) \times 4.4}{Y}</math> |
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V= The value expected from the growth formulas over the next 7 to 10 years<BR> |
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V: Intrinsic Value<BR> |
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EPS |
EPS= the company’s last 12-month earnings per share<BR> |
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8.5 |
8.5= the constant represents the appropriate P-E ratio for a no-growth company as proposed by Graham<BR> |
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g |
g= the company’s long-term (five years) earnings growth estimate<BR> |
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4.4 |
4.4= the average yield of high-grade [[corporate bond]]s in 1962, when this model was introduced <ref>see [https://www.bloomberg.com/markets/rates-bonds/corporate-bonds/ FINRA/Bloomberg Investment Grade U.S. Corporate Bond Index], [[bloomberg.com]] for current average.</ref><BR> |
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Y |
Y= the current yield on 20 year AAA corporate bonds.<ref>{{cite web|title=Benjamin Graham’s Valuation Formula for Growth Stocks|url=http://www.stockopedia.com/content/benjamin-grahams-valuation-formula-for-growth-stocks-60732/#sthash.1U5l33mj.dpuf}}</ref> |
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==Application== |
==Application== |
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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. |
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. |
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Graham was careful to note that this formula was not being recommended for use by investors-- rather, it was to model the expected results of other growth formulas popular at the time.<ref name=":0" /> However, a misconception arose that he was using this formula in his daily work due to a later edition's decision to move footnotes to the back of the book, where fewer readers searched for them.<ref>{{Cite web|url=https://www.serenitystocks.com/benjamin-graham-formula|title=Understanding The Benjamin Graham Formula Correctly {{!}} Serenity Stocks|website=www.serenitystocks.com|language=en|access-date=2017-07-18}}</ref> This has led to an assortment of advisors and investors recommending this formula (or revised versions of it) to the public at large; a practice that continues to this day.<ref name=":0" /><ref>{{cite web|url=http://www.joshuakennon.com/benjamin-graham-intrinsic-value-formula/|title=Benjamin Graham Intrinsic Value Formula|date=15 July 2011|publisher=Kennon & Green Press, LLC|work=JOSHUA KENNON blog|accessdate=14 April 2012|author=JOSHUA KENNON}}</ref> Indeed, Benjamin Clark, the founder of the website and investment service ModernGraham, argues that "I consider the footnote to be more of a reminder from Graham that the calculation of an intrinsic value is not an exact science and cannot be done with 100% certainty."<ref>{{Cite web|url=http://www.moderngraham.com/2015/09/09/how-to-tell-the-difference-between-the-graham-formula-and-the-graham-number/|title=How to Tell the Difference Between the Graham Formula and the Graham Number|last=9|first=September|last2=2015|date=2015-09-09|website=ModernGraham|access-date=2017-07-18}}</ref> |
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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. |
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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: |
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Graham also cautioned that his calculations were not perfect, even in the time period for which it was published, noting in the ''Fourth Revised Edition'' of ''[[The Intelligent Investor]]'': "We should have added caution somewhat as follows: The valuations of expected high-growth stocks are necessarily on the low side, if we were to assume these growth rates will actually be realized." He continued on to point out that if a stock were to be assumed to grow forever, its value would be infinite.<ref name=":0" /> |
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*Net Current Asset Value in order to determine the financial viability of the firm in question |
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*Current Asset Value in order to determine short-term financial viability of the firm |
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*[[Debt to assets ratio|Debt to equity ratio]] |
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*Quality of the Current Assets. |
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==References== |
==References== |
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Revision as of 01:53, 18 July 2017
 | This article needs additional citations for verification. (December 2011) |
The Benjamin Graham formula is a formula proposed by investor and professor of Columbia University, Benjamin Graham, often referred to as the "father of value investing"[1]. Published in his book, The Intelligent Investor, Graham devised the formula for lay investors to help them model growth formulas in vogue at the time of the formula's publication.[2]
Formula calculation
In Graham's 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 = The value expected from the growth formulas over the next 7 to 10 years
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
Revised formula
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 straightforward 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= The value expected from the growth formulas over the next 7 to 10 years
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 [3]
Y= the current yield on 20 year AAA corporate bonds.[4]
Application
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:
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.
Graham was careful to note that this formula was not being recommended for use by investors-- rather, it was to model the expected results of other growth formulas popular at the time.[2] However, a misconception arose that he was using this formula in his daily work due to a later edition's decision to move footnotes to the back of the book, where fewer readers searched for them.[5] This has led to an assortment of advisors and investors recommending this formula (or revised versions of it) to the public at large; a practice that continues to this day.[2][6] Indeed, Benjamin Clark, the founder of the website and investment service ModernGraham, argues that "I consider the footnote to be more of a reminder from Graham that the calculation of an intrinsic value is not an exact science and cannot be done with 100% certainty."[7]
Graham also cautioned that his calculations were not perfect, even in the time period for which it was published, noting in the Fourth Revised Edition of The Intelligent Investor: "We should have added caution somewhat as follows: The valuations of expected high-growth stocks are necessarily on the low side, if we were to assume these growth rates will actually be realized." He continued on to point out that if a stock were to be assumed to grow forever, its value would be infinite.[2]
References
- ^ Dave, John (2014). Benjamin Graham: The Father of Value Investing. CreateSpace Independent Publishing Platform). ISBN 1500653748.
- ^ a b c d Graham, Benjamin (2006). The Intelligent Investor: Revised Edition. First Collins Business Essentials. pp. 295, 585. ISBN 0-06-055566-1.
- ^ see FINRA/Bloomberg Investment Grade U.S. Corporate Bond Index, bloomberg.com for current average.
- ^ "Benjamin Graham's Valuation Formula for Growth Stocks".
- ^ "Understanding The Benjamin Graham Formula Correctly | Serenity Stocks". www.serenitystocks.com. Retrieved 2017-07-18.
- ^ JOSHUA KENNON (15 July 2011). "Benjamin Graham Intrinsic Value Formula". JOSHUA KENNON blog. Kennon & Green Press, LLC. Retrieved 14 April 2012.
- ^ 9, September; 2015 (2015-09-09). "How to Tell the Difference Between the Graham Formula and the Graham Number". ModernGraham. Retrieved 2017-07-18.
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