Monday, March 25, 2013

Stock Valuation Method - Graham Number

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.

19 comments:

  1. Hi PIP,

    Thanks for your post on my comment last week. As your well aware its a deep field so getting advice from independent people is badly needed for us newbies.

    Thanks for this and I look forward to next weeks post.

    Cheers,

    Gordon

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    1. Gordon,

      Glad to help. I've been following DGI for about 1.5 years now and I've still got lots to learn. The budding community that is forming is great because it allows us to bounce ideas off each other and every one seems to be covering a different concept at any given time.

      I hope this was helpful. I actually got off my butt to write this series after your comment. I'd been planning to cover it for a while but just never got around to it. Thanks for the push to finally get it out there.

      Thanks for stopping by!

      Delete
  2. Great explanation of the Graham valuation number. I'm currently reading through the Intelligent Investor by Graham and it is a pretty challenging read. Full of great information though and I'd recommend it as required reading for any serious investors.

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    1. Dan Mac,

      I'm close to finishing The Intelligent Investor. I read almost all of it and then it got put on the backburner along with most of my reading. I agree it is a challenging read and one that needs to be revisited every now and then to see some things you missed the first, second, third...times that you've read it. It's definitely required reading for any serious investors, especially those with a value tilt.

      Thanks for stopping by!

      Delete
  3. Thanks for this! I really enjoy your stock analysis posts, but always wonder what the specifics of the methods you use are, and particularly where you look for all the data you use! Very much looking forward to more of these posts.

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    1. Michael D,

      Glad to have you checking in. I received a comment recently that raised the question about more information on DGI. I'm working on getting some posts about it but in the meantime started the stock valuation series. I haven't seen too many explanations of different valuation techniques so I figured I'd get something together and I'm glad this was helpful.

      If you have any other questions or topics you'd like covered feel free to leave another comment or using the contact form. Sometimes it's hard coming up with new topics to cover, so there's any sticking points that you have I'll gladly do my best to come up with an explanation.

      Thanks for stopping by!

      Delete
  4. Thanks for explaining the Graham number! I typically use other valuation techniques to arrive at a fair value price, but that is not to say the Graham number isn't useful.

    Many top dividend growth stocks have a p/b that is significantly higher than 1.5. That might be the reason the Graham number usually seems way off. For example JNJ has a p/b of 3.4, KO is 5.5. Some wonderful companies even have a negative book value, PM is an example there.

    I tend to rely more on DDM, DCF, historical p/e, and historical yield. These all provide ways to measure value. When they are close I feel pretty confident.

    Cheers!

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    1. CI,

      There's definitely limitations but who am I to go against the father of value investing? This is why I always use multiple valuation methods to come up with a price. I'll be covering all of the methods you mentioned later in the series.

      Thanks for stopping by!

      Delete
  5. To be checked against the Graham Number, Benjamin Graham required that a stock first have uninterrupted earnings for the previous 10 years, uninterrupted dividends for the previous 20 years, and meet 4 other Defensive criteria.

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    1. I covered that previously on the linked series on The Intelligent Investor but you're right I probably should have mentioned the rest of the criteria.

      Thanks for stopping by!

      Delete
  6. I personally use this valuation metric as a screening method, but I think you hit the nail on the head when you pointed out this is just but one method.

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    1. Marvin,

      I think it's a good metric to use whether in the screening process or when trying to determine a value. I wouldn't rely on any single metric to come up with an investment thesis for a stock so it's just one of many tricks.

      Thanks for stopping by!

      Delete
  7. What a very interesting lesson. I'm always curious as to hear about if the teachings of Graham will still hold merit for the market today given all that has changed.

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    1. MMD,

      I've wondered the same thing but I think the general ideas are still applicable. The biggest thing he preached in The Intelligent Investor was a margin of safety which works in any market. Some of the numbers might not be truly relevant because the general market valuations might have been different, although who am I to say that it doesn't work anymore. He's got a lot more experience and knowledge than I could ever hope to have.

      Thanks for stopping by!

      Delete
  8. Thanks for sharing this. I tried to read Graham's book, but never finished. It was too dry for me to read it. I definitely give it another shot and add the Graham number to one of my evaluation methods.

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    1. Martin,

      It's definitely a hard read, but there's a lot of great information in there.

      Thanks for stopping by!

      Delete
    2. This is a good site to spent time on .I just stumbled upon your informative blog and wanted to say that I have really enjoyed reading your blog posts.

      Delete
  9. I have a lot of respect for warren buffett as a value investor. I also admire Ben Graham. What I do not understand is how anyone that is a value investor can overlook the tremendous value of a decent company with a very low price to sales ratio. This value metric is so simple yet so misunderstood. If I can buy a decent company that does 1 billion dolars in annual sales for just 100 million dollars. I have the advantage period. Stocks of decent quality that have very low price to sales ratios can have tremendous price potential. I know dozens of companies that have increased five ten even twenty fold over a period of years that had very low price to sales ratios. I would be happy to name a few Petsmarts' Netflix' Seaboard' Tractor supply' pricesmart' Laboratory Corp of America Holdings' all of these companies increased over ten fold over a five to fifthteen year period. Netflix trades over 200 today it traded at 3 in 2002 Laboratory Corp of America Holdings traded at 3 dolars in 1998 today its trading over 90. Pricesmart traded at 6 dollars in 2004 today it trades at 87. Petsmart traded at 2 dollars in the year 2000 today it trades over 70. Seaboard traded at 180 dollars a share in the year 2000 today seaboard trades at 2700 dollars. Tractor Supply traded at 1 dollar in the year 2000 today tractor supply trades at 113. And what did all of these companies have in common they all were decent companies with very low price to sales ratios. I got the info from yahoo finance interactive charts which shows the historical price range for all stocks. As I have demonstrated a very low price to sales ratio could very well be the single most important factor when investing in value stocks.

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  10. Great discussion and I'm glad there is more talks about Graham. He was a great investor and this is one quick way to filter companies. To add to this, Graham also added more criteria along with this number.
    You can see more details in the link I posted, but basically, he wanted defensive investors to sleep well at night by buying solid and well established companies. Strong balance sheet and low debt.

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