The Graham Number: Evaluating Stock Value with Examples and Methodology

Summary:

The Graham number, developed by legendary investor Benjamin Graham, is a crucial metric for evaluating a stock’s fundamental value. By factoring in earnings per share (EPS) and book value per share (BVPS), this article explores the formula, its significance, alternative calculations, and limitations. Learn how Graham’s number sets a maximum stock price, making any stock priced below it attractive for value investors. Discover the role of Benjamin Graham, a pioneer in value investing, and how the Graham number aligns with his principles.

What is graham number?

The world of finance is rich with metrics and ratios designed to guide investors in their decision-making process. One such metric, the Graham number, stands out as a fundamental measure of a stock’s value. Named after the renowned investor Benjamin Graham, this number combines two critical elements: earnings per share (EPS) and book value per share (BVPS). In this comprehensive exploration, we will delve into the intricacies of the Graham number, understanding its formula, significance, alternative calculations, and limitations. Join us on a journey through the philosophy of Benjamin Graham and the practical application of the Graham number in value investing.

The formula for the Graham number

The Graham number serves as a compass for investors, guiding them to the highest price they should pay for a stock. The formula is elegantly simple: 22.5 times the product of earnings per share (EPS) and book value per share (BVPS). This calculation aligns with Benjamin Graham’s philosophy of maintaining a price-to-earnings (P/E) ratio below 15x and a price-to-book (P/B) ratio below 1.5x. The 22.5 multiplier encapsulates this ‘ideal’ balance, providing investors with a clear benchmark to assess a stock’s true value.

Understanding the Graham number

Benjamin Graham, often referred to as the “father of value investing,” believed in a disciplined approach to stock valuation. The Graham number is a manifestation of this philosophy, offering investors a litmus test for identifying stocks selling at an attractive price. The inclusion of the 22.5 factor harmonizes the relationship between earnings and book value, aligning with Graham’s vision of prudent investing.

Alternative calculation

For those seeking an alternative perspective, the Graham number can also be calculated by multiplying net income, shares outstanding, and shareholders’ equity by 15 and 1.5, respectively. This method reinforces the equivalence between earnings, shares outstanding, and book value per share, emphasizing the consistency of Graham’s principles across different formulations.

Example of the Graham number

To illustrate the practical application of the Graham number, consider a hypothetical stock with an EPS of \$1.50 and a BVPS of \$10. Applying the formula yields a Graham number of 18.37. This implies that any price below \$18.37 is deemed attractive for investors, in accordance with Graham’s guidelines. Such a concrete example demonstrates how the Graham number provides a tangible benchmark for evaluating stock prices.

Limitations of the Graham number

While the Graham number offers valuable insights, it is essential to acknowledge its limitations. The metric solely focuses on EPS and BVPS, omitting crucial factors such as management quality, major shareholders, industry characteristics, and the competitive landscape. Investors should supplement their analysis with a broader fundamental approach to ensure a comprehensive evaluation of a stock’s potential.

What is a good Graham’s number?

Understanding what constitutes a “good” Graham’s number is pivotal for investors. Graham’s number establishes the maximum stock price based on a company’s EPS and BVPS. Therefore, any stock priced below this calculated figure is considered a favorable opportunity for value investors. This aligns seamlessly with Benjamin Graham’s overarching philosophy of identifying undervalued opportunities through meticulous financial statement analysis.

How does the Graham number work in value investing?

At its core, the Graham number normalizes a company’s per-share metrics, incorporating a recommended limit of 15x P/E and 1.5x P/B for value investors. By applying this normalization, the Graham number ensures a balanced assessment of a stock’s intrinsic value. Investors following Benjamin Graham’s principles find this metric invaluable in guiding their investment decisions, as it aligns with the principles of value investing.

Who was Benjamin Graham?

Benjamin Graham, a luminary in the world of finance, is regarded as one of the founding fathers of value investing. His influence extends to some of the most successful investors, including Warren Buffett. Graham’s philosophy emphasized a thorough examination of a company’s financial statements to identify undervalued opportunities. His seminal work, “The Interpretation of Financial Statements,” remains a cornerstone text for value investors seeking to navigate the complexities of stock valuation.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and drawbacks to consider.

Pros
• Provides a clear benchmark for determining the maximum price to pay for a stock.
• Aligns with the principles of value investing, emphasizing a balanced approach to earnings and book value.
• Offers a tangible metric for identifying undervalued opportunities in the stock market.
Cons
• Excludes important factors such as management quality, major shareholders, and industry characteristics.
• Relies solely on historical financial metrics, potentially overlooking emerging trends or changes in a company’s trajectory.
• Should be used in conjunction with other fundamental analysis tools for a comprehensive assessment.

Can the Graham number change over time?

Yes, the Graham number can fluctuate as a company’s EPS and BVPS change. It is essential for investors to regularly reassess stocks based on updated financial metrics to make informed investment decisions.

Does the Graham number account for industry-specific characteristics?

No, the Graham number focuses primarily on a company’s EPS and BVPS and does not consider industry-specific characteristics. Investors should complement their analysis with an understanding of the industry in which a company operates.

Is the Graham number applicable to all stocks?

While the Graham number provides valuable insights, it may not capture all aspects of a stock’s potential. Factors like management quality and industry characteristics are not considered in its calculation. Investors should use it as one tool among many in their analysis.

Key takeaways

• The Graham number, created by Benjamin Graham, gauges a stock’s fundamental value.
• It considers earnings per share (EPS) and book value per share (BVPS).
• Stocks priced below the Graham number are deemed undervalued, making them attractive for investors.
• Benjamin Graham, a value investing pioneer, emphasized the importance of financial statement analysis.
• The Graham number is calculated as 22.5 times the product of EPS and BVPS.
• An alternative calculation involves multiplying net income, shares outstanding, and shareholders’ equity by 15 and 1.5, respectively.
• Limitations include the exclusion of key factors like management quality, major shareholders, and industry dynamics.
View article sources
1. Nobody comprehends Graham’s number – Carnegie Mellon University
2. Guinness Book of World Record – University of California San Diego
3. Prospective evaluation of biopsy number in the diagnosis – National Library of Medicine
4. District Detail for Graham School – National Center for Education Statistics
5. Demystifying Benjamin Graham’s Intrinsic Value Formula – SuperMoney