This is the first of my series on different valuation methods for analyzing stocks. If you have a commonly used metric named after yourself you must be doing something right. And it doesn't hurt that you also taught Warren Buffet, who happens to be one of the greatest investors of all time. Those two reasons alone should be enough to consider the Graham Number a useful tool, but what exactly is it.
It was derived by taking two of his requirements from The Intelligent Investor and creating a formula to account for them. The formula for the Graham Number is the square root of (22.5 x TTM Earnings per share x Book Value per share). This calculation gives the maximum price that a potential investor should pay for shares in a prospective investment. The earnings per share and book value per share are pretty straight-forward, but where does the 22.5 come from? According to Graham, the most that an investor should pay for an investment is a 15 price-to-earnings ratio and 1.5 price-to-book ratio. If you take the 15 P/E x 1.5 P/B, that equals the 22.5.
Let's take a closer look at the different components of the calculation. TTM Earnings per share is pretty straight-forward. Most financial websites have this value provided for you already. Earnings per share are calculated as the net income divided by the shares outstanding. Net income can be found on the income statement when a company reports it's quarterly or annual results. If it is in the middle of a company's fiscal year, you'll need to look through the last 4 quarterly reports and sum them up to use in the calculation.
Shares outstanding can also be found on the income statement. You'll need to take a look at the most recent quarterly filing from the company. The value will be close to the bottom of the income statement. Shares outstanding come in 2 varieties. The basic shares outstanding is the common shares currently available on the market. The fully diluted shares outstanding accounts for all potential shares from stock options, warrants, and convertible bond issues. I prefer to use the fully diluted shares outstanding because it represents the total potential shares that could be on the market in the future.
Book value per share can also be broken down into its components. It is simply the shareholder's equity divided by the shares outstanding. Shareholder's equity is calculated by subtracting the total liabilities of the company from the total assets. It is essentially the amount that would be left over if the business was liquidated and all debts paid off or the net worth of the company. What remains would be divided equally among the shareholders. You can find the total assets and total liabilities values from the most recent quarterly or annual report on the balance sheet section of the filing. We've already obtained the shares outstanding earlier, so now you simply divide it into the shareholder equity to arrive at the book value per share.
While the Graham Number is a good quick calculation to make, it is but one valuation technique. One calculation simply can't incorporate all the metrics necessary to determine whether an investment is worthy of your hard earned dollars. Next week we'll look at another valuation method.
You can obtain the quarterly and annual reports at the company's investor relations website or at EDGAR Online. Yahoo! Finance also provides a direct link to a company's filings if you go to the company listing on Yahoo! Finance and click on SEC filings on the navigation bar. The quarterly reports are filed as 10-Q and annual reports are filed as 10-K.