Graham Number

The Graham Number is a financial metric used to determine the intrinsic value of a stock. It was derived by Benjamin Graham, who is often referred to as the father of value investing. Graham’s investment philosophy focused on purchasing stocks that were undervalued by the market but possessed strong fundamentals. The Graham Number helps to identify such undervalued stocks.

Definition and Formula

The Graham Number is calculated using the following formula:

Graham Number = sqrt(22.5 * [Earnings](../e/earnings.html) Per Share (EPS) * [Book Value](../b/book_value.html) Per Share (BVPS))

Where:

[Earnings](../e/earnings.html) Per Share (EPS) refers to the company’s profit divided by the number of outstanding shares.
[Book Value](../b/book_value.html) Per Share (BVPS) is the net asset value of the company divided by the number of outstanding shares.

The multiplier 22.5 in the equation comes from Graham’s criteria that the Price-to-Earnings (P/E) ratio should not exceed 15 and the Price-to-Book (P/B) ratio should not exceed 1.5. Multiplying these two values gives us 22.5, which is used in the formula.

Purpose and Importance

The Graham Number serves as a benchmark to assess whether a stock is trading below its intrinsic value. If the stock’s current market price is below the Graham Number, the stock may be considered undervalued and potentially a good investment opportunity. Conversely, if the market price is above the Graham Number, the stock might be overvalued.

Example Calculation

Let’s consider a hypothetical company with the following financial metrics:

Earnings Per Share (EPS): $5
Book Value Per Share (BVPS): $40

Using the Graham Number formula:

Graham Number = sqrt(22.5 * 5 * 40)
              = sqrt(22.5 * 200)
              = sqrt(4500)
              = 67.08

If the stock’s current market price is $60, it would be considered undervalued relative to its Graham Number value of $67.08.

Limitations

While the Graham Number is a useful tool, it is not without limitations:

Static Calculation: The formula uses historical EPS and BVPS, which may not accurately reflect future company performance.
Ignoring Growth: The Graham Number does not account for growth potential, which could mean undervaluing high-growth companies.
Industry-Specific: Different industries have different P/E and P/B norms; the Graham Number may not be equally applicable across diverse sectors.

Practical Application

Screening Stocks

Investors often use the Graham Number as part of a stock screening process to identify potentially undervalued stocks. Several financial websites and platforms offer pre-calculated Graham Numbers for many publicly traded companies, making this process easier.

Portfolio Management

Value investors might incorporate the Graham Number into their portfolio management strategy to ensure they are investing in stocks that meet their valuation criteria. This can help in making more objective investment decisions based on fundamental analysis rather than market sentiment.

Risk Management

By focusing on stocks trading below their Graham Number, investors can potentially reduce their downside risk. Purchasing undervalued stocks provides a margin of safety, which is a core principle of value investing. The assumption is that the market will eventually recognize the stock’s true value, leading to price appreciation.

Case Studies

Apple’s Graham Number

For example, let’s calculate the Graham Number for Apple Inc. (AAPL) using their financial data as of the most recent fiscal year:

Earnings Per Share (EPS): $5.61
Book Value Per Share (BVPS): $3.85

Graham Number = sqrt(22.5 * 5.61 * 3.85)
              = sqrt(22.5 * 21.5985)
              = sqrt(485.965125)
              = 22.05

If Apple’s current market price is $150, it is significantly higher than its Graham Number of $22.05, suggesting that it might be overvalued according to this metric.

Amazon’s Graham Number

As another example, consider Amazon.com Inc. (AMZN) with the following data:

Earnings Per Share (EPS): $42.64
Book Value Per Share (BVPS): $211.61

Graham Number = sqrt(22.5 * 42.64 * 211.61)
              = sqrt(22.5 * 9021.3504)
              = sqrt(202980.384)
              = 450.53

If Amazon’s market price is $3,200, it is far above its Graham Number of $450.53, indicating potential overvaluation.

Conclusion

The Graham Number is a simplistic yet powerful tool for value investors seeking to identify undervalued stocks. It simplifies the complex task of stock valuation into a single, quantifiable metric that can be used to make informed investment decisions. However, it is essential to use the Graham Number in conjunction with other financial analysis tools and considerations to ensure a comprehensive understanding of a stock’s value. Despite its limitations, the Graham Number remains a testament to Benjamin Graham’s enduring influence on the art and science of investment.