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

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