Estimating Benjamin Graham Number
Graham number is one of the five method I use to estimate the fair value of a given company share that I am willing to pay. I have provided the formula I use and a very brief description. However, over the last few weeks, I have received questions requesting to help explain why this particular formula and is there any rationale on how this is derived. So here it is…..
Graham’s view was the price-to-earnings ratio should not be more than 15. At the same time, price-to-book value should not be more than 1.5. He also mentioned that it would be justifiable to have higher P/B ratio if PE ratio is below 15.
With this thought process, Graham proposed that the product of these two parameters should not be more than 22.5
[ P/E] x [P/B] = 15 x 1.5 = 22.5
P^2 = 22.5 x E x B
Price = Square Root [22.5 x Earnings x Book Value]
Price per share = Square Root [ 22.5 x EPS x BV per share ]
Now let us look at each individual element and understand significance or implications.
- Price per share is self explanatory.
- Book Value: In simple terms, book value is the value of assets mentioned on the balance sheet. This BV mentioned in company balance sheet is simple the original value of the assets, minus depreciation/amortization/impairment cost. However, in modern times, if the company is liquidated, the shareholder will never receive the book value. This is because almost all companies have some form of intangibles like goodwill, patents, licenses, contractual rights and obligations, etc. These are not used on calculating the BV in company balance sheets. Therefore, many folks use “tangible book value”. This is the value a shareholder can expect if and when it gets into liquidation. For now, in my calculations, I am using BV as mentioned in the balance sheet. I plan on using tangible BV in future after I setup my process to make this calculation.
- Earnings per share (EPS) is also self explanatory. I do not use a standalone trailing 12 months EPS. I use average of trailing 3 years. This helps normalize any positive or negative unusual swings in recent past. This is more important for a growth economy like ours where I see big differences.
- The last piece of the puzzle is about the number 22.5. This is the product of 15 x 1.5. So why choose 15? The reason is Graham wanted his portfolio yield that is equal to yield of AA rated bonds (high rating in those days). In those days, AA bonds were yielding 7.5%. So to have it equal yield you need to take inverse (1 divided by 7.5%). This comes to 13.3. There is school of thought that he rounded this to 15 for simplifying the calculation. I do not know if there is any other reason for this rounding to 15. But who am I to question Graham or any other folks. Right? There are certain things you just accept because we cannot prove it wrong. The same goes with 1.5. Graham believed P/B as 1.5, so it is. If anybody knows what the logic behind 1.5, please let me know in comments section below.
Can you see the holistic nature of Graham Number? This number takes into consideration all three metrics that would be important to a shareholder, i.e. price of each share (what price are we paying to buy that business asset), the book value (what is it value if we liquidate it), and yield (how much it is yielding to the shareholder on continual basis).
I hope this helps explain the Graham Number. Now go out and suggest me and readers of this blog some good stocks trading are Graham Number.
Final Note: I use Graham Number in conjunction with other information also. I never use is on standalone basis.
book value, estimating intrinsic value, graham number, intrinsic value, tangible book value.
Just to add my 2 paise..
My experience is excellent with using IRR 12.5 in DCF calculation vs graham’s 15. It gives pessimistic output but it helps in keeping MoS at 50%
Graham is great no doubt about it. but Due diligence is also equally important than following blindly. TIP Guy, You are doing the right thing as mentioned in the Final Note.
Just thought to share.
MIP
@ My Income,
what is IRR and why 12.5, what is justification?
thanks
(With permission of TIP guy i would like to explain)
It’s the same as explained by TIP Guy.
Graham take AA bonds yield, In present indian scenario I am comfortable with PPF risk free returns of 8% as standard yield. So 1/8 = 12.5%
Further this 12.5% is used as discount factor in discounting future cash flows back in present value (PV)
No two persons will arrive at the same conclusion in these methods.
MIP
MIP,
Always welcome your comments…. Thanks for the initiative.
I use 12 to 13% for my DCF calculations (one of the method I use for fair valuation).
Best Wishes,
IRR, is Internal Rate of Return. means the rate you expect your returns will grow over the period. basically it’s the same rate used to discount future cash flow in today’s value.
Hi,
Going by your mentioned formula, most of the stocks mentioned in my magic folmula sheet are trading way below the Grahams Number !!!! Some like Oscal finance are ourageously below. It would be helpful if you can check those and post your comments.
Rgds
Investologic
Hello Investologic,
Grahams Number is just one input. You have to look at others also. I will check it out. Thanks for the suggestion.
Best Wishes,
In the P/B context we are looking at the Book Value available per share. In the case of a liquidation, share holders are paid only after the debt holders. For that reason, we should substract all liabilities from the book value before dividing it by the number of common shares outstanding to calculate the BV per share. Maybe that’s where your sheet goes wrong?
Hello Jaco,
Yes, shareholder will not get paid the BV mentioned in the balance sheets. I did mention this in my discussion. I also mentioned I am working to figure out tangible book value for the calculations. I expect that the implications of using BV (or not using tangible book value) would be tempered considering Indian growth prospects.
Best Wishes,
Nice post infact.
I remember reading it long back though I couldn’t recollect the source.
Nice recollecting it.
Hi Sir
while these numbers are good i would honestly disagree with you about comapnies such as Nestle, HUL , Titan which despite kicks and crashes remain above the valuations . In fact these are some companies which go from expensive to very expensive list
Hello Bhushan,
I did not understand, on what point did you disagree?
Best Wishes,
Why not average book value also over a three year period?
Hello Abirama,
Certainly you could, if it makes sense for your objectives.
Downside is book value is not something that one can average. It depends on your assets and liabilities. High liability will remain high. Averaging out will not reduce companies liabilities.
On the other hand you could use trends to understand how company management is doing on this metric.
Best Wishes,
hi, friends, I am new to value investing and learning.As per tip guy formula,Renaissance Jewellery Ltd is valuation is 266.92 and the stock price is 81 . so Its value buying Am I righ. I took three years eps in calculation. Can you suggest some more calculation to be kept in mind for lay man while purchasing stock. I got this data from economictimes website.
Hello Jayesh,
You forgot to read the “Final Note”. Selective amnesia?
Good Luck!