What is the Graham Number?
Benjamin Graham, a mentor to Warren Buffet and the father of ‘value investing’, gave the concept of Graham number or Benjamin Graham’s number - a formula that helps identify undervalued stocks. This article details the answer to ‘what is the Graham number.’
Graham Number
The Graham number represents the fair valuation of a stock. It is the maximum amount that a defensive investor will be ready to pay to buy the stock. According to Benjamin Graham, a defensive investor is the one who is unwilling or unable to put time or effort into his investment decisions. Defensive investors can be deemed to be passive investors. A stock trading below its Graham number is ‘undervalued’.
The Graham number considers Earnings Per Share (EPS) and Book Value Per Share (BVPS) to find a stock’s maximum fair market value. It is interesting to note that Benjamin Graham never proposed this formula directly. He underscored a stock selection analysis in his bestselling book, ‘The Intelligent Investor’. The study was narrowed down to the ‘moderate price to assets ratio’. Analysts further refined this ratio into the Graham number formula. The moderate price to assets ratio states that:
- Stocks can provide better returns from assets, up to 15 times the earnings.
- The stock's current price should not be more than the book value multiplied by 1.5.
The Graham number has been widely used for the last five decades. It helped investors pick underpriced stocks for investment. However, it can not be reliably used in asset-light businesses. This becomes very significant in today’s world, where companies are hovering towards technology for all big and small needs. Nonetheless, for asset-based businesses, the Graham number still holds good.
The Graham number is also not advised to be used in isolation. Investment decisions should be comprehensive, and other factors such as management quality, sector analysis, and the overall financial health of the target company should also be kept in mind.
The formula to calculate the fundamental value of a stock using the Graham number is as follows:
Where;
- Earnings Per Share = Net income ÷ No. of outstanding shares
- Book Value Per Share = Shareholder's equity ÷ No. of shares outstanding
- 22.5 is based on Graham’s assumption that an undervalued stock’s price-to-earnings ratio (PE ratio) should not exceed 15, and the price-to-book ratio (PB ratio) should not exceed 1.5. Hence the number 22.5 =(15 × 1.5), i.e., PB ratio × PE ratio.
Therefore, an alternate formula for the Graham Number can be
- The Graham formula does not apply to companies running in losses or are asset-light.
- The price-to-earning ratio of the concerned company should not be more than 15.
- Likewise, the price-to-book ratio should not be more than 1.5. The formula is inapplicable if the ratio goes beyond 1.5.
Example of Graham Number
Ms P wants to buy the shares of ABC Co. Ltd. She does not have the time to look closely at the company’s financials. Being a defensive investor, she decides to use the Graham number to judge whether ABC Co. Ltd’s shares are a good buy. The company’s earnings for the year are INR 40,00,000. Shareholders’ equity is INR 600,000, and outstanding shares are 500,000. This is how Ms P calculates the Graham number of ABC Co. Ltd:
Earnings Per Share = Net income ÷ No. of outstanding shares
⇒ Earnings Per Share = 40,00,000 ÷ 5,00,000
⇒ Earnings Per Share = INR 8
Book Value Per Share = Shareholder's equity ÷ No. of shares outstanding
⇒ Book Value Per Share = 6,00,000 ÷ 5,00,000
⇒ Book Value Per Share = INR 1.2
Graham Number = sqrt
⇒ Graham Number = sqrt
⇒ Graham Number = 14.6969
If the stock is trading below INR 14.6969, Ms P should buy it. However, stock trading above INR 14.6969 implies that it is overvalued and should be avoided.
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Frequently Asked Questions
Ans: Calculating the Graham number is an easy method to find whether the stock is undervalued or overpriced. An investor can quickly decide whether to purchase or sell shares based on the Graham number. A discount to the Graham number alone does not signify a fundamentally strong company.
Though the calculation takes only a few minutes, it ignores many critical fundamental characteristics and ratios of the company. Hence, a combination of Graham number and other ratios and statistical analysis tools such as return on capital employed, debt analysis, return on equity, cash flow analysis, etc., needs to be used to identify promising, strong and fundamentally sound companies. The Graham number is an easy starting point for an investor’s research but is certainly not foolproof.
The Graham number tells us whether a stock is underpriced or overpriced. It is the highest value that a defensive investor should pay to buy the stocks of a company. If the Graham number is high and the stock is priced low, the stock is undervalued. Undervalued stocks are considered a good investment opportunity. There is no standard Graham number that is regarded as good or bad.
Value investing is a long-term strategy that is based on the principle of buying and holding undervalued securities. Graham number helps in discovering the intrinsic value of the stocks. If the company’s shares trade above its Graham number, they are overvalued and should not be purchased. Shares trading below the Graham number are undervalued and fit for purchase. Thus, the Graham number helps investors find undervalued stocks and saves them from paying more than their fair value.