Graham Number is a way to estimate the intrinsic value of a company based on its book value and earnings power. It is the upper bound of the price range that a defensive investor should pay for a stock. Any stock price below the Graham Number is considered undervalued and thus worth investing in.
Formula : Square root of (22.5 x Earnings per Share x Book Value per Share)
Graham Number is based on the criteria No. 6 and 7 of "Stock Selection for the Defensive Investor" (The Intelligent Investor, chapter 14), which state that:
- Moderate Price/Earnings ratio - Current price should not be more than 15 times average earnings of the past three years.
- Moderate Ratio of Price to Assets - Current price should not be more than 1.5 times the book value last reported.
As a rule of thumb, Graham suggests that the product of the multiplier times the ratio of price to book value should not exceed 22.5.
The remaining 5 criteria for "Stock Selection for the Defensive Investor" are:
- Adequate Size - Steer clear of stocks with a total market value of less than $2 billion (2003 figure).
- Strong Financial Condition - Current assets should be at least twice current liabilities (Current ratio =>2). Also the long term debt should not exceed the net current assets.
- Earnings Stability - Some earnings for the common stocks in each of the past ten years.
- Dividend Record - Uninterrupted payments for at least the past 20 years.
- Earning Growth - A minimum increase of at least one-third in per-share earnings in the past ten years using three-year averages at the beginning and end.
Graham Number is a very simple and conservative way to valuate a company, but it does have its limitation.
- It does not take growth into the valuation and tends to underestimates the values of the companies that have good earnings growth.
- It can only be applied to companies with positive earnings and positive book values.
- It punishes companies that have temporarily low earnings and underestimates medium-to-large-cap companies that are low with book value.
Example of Graham Number Calculation :
The EPS and Book Value per Share for Cisco is 1.51 and 9.60 respectively. The Graham Number is calculated as follows:
Graham Number = Square root of (22.5 x 1.51 x 9.60) = Square root (326.16) = $18.06 per share.
Graham Number should not be used alone while evaluating a stock for defensive investment, it should be used along with the other 5 criteria as outlined above. If a stock does not meet any one of the 7 criteria, then it should be checked against the 5 criteria for "Stock Selection for the Enterprising Investor" (The Intelligent Investor, chapter 15).
- Financial Condition - a) Current assets at least 1.5 times current liabilities and b) Debt not more than 110% of net current assets.
- Earning Stability - No deficit in the last five years covered in the Stock Guide.
- Dividend Record - Some current dividend.
- Earnings Growth - Last year's earnings more than those of 1966. (Note : The revised edition of The Intelligent Investor was updated by Benjamin Graham in 1971-72, therefore we should compare the last year's earnings against those of 2008).
- Price - Less than 120% net tangible assets.
The Intelligent Investor, by Benjamin Graham