How to Value a Stock with the Benjamin Graham Formula

December 1, 2009 | Comments (38)

Written by

Jae Jun

follow me on

Facebook

Twitter

How to value stocks series

For other posts in the series, follow the links below.

Quick Word on the Science and Art of Valuation

Valuation is an art.

Assumptions are needed to perform any type of analysis as the whole topic of stock valuation is forward looking.

Throughout these valuation exercises, it’s important to understand that the final stock value will vary based on the assumption of scenarios.

Instead of trying to pinpoint one number, the science behind valuing stocks is to come up with a range of values. By doing so, it helps you to think about the downside as well as the upside possibilities.


Now, let’s see how Graham valued stocks.

Using Benjamin Graham’s Formula to Value a Stock

Benjamin Graham Formula

The Benjamin Graham Formula was Created by this man.

The second method I use to value a stock is by using Benjamin Graham’s formula from The Intelligent Investor.

With the extremely popular free Ben Graham stock spreadsheet I offer, the stock valuation method deserves a closer look.

Benjamin Graham Formula

The original formula from Security Analysis is

graham-formula-old

where V is the intrinsic value, EPS is the trailing 12 month EPS, 8.5 is the PE ratio of a stock with 0% growth and g being the growth rate for the next 7-10 years.

However, this formula was later revised as Graham included a required rate of return.

graham-formula-update

The formula is essentially the same except the number 4.4 is what Graham determined to be his minimum required rate of return. At the time of around 1962 when Graham was publicizing his works, the risk free interest rate was 4.4% but to adjust to the present, we divide this number by today’s AAA corporate bond rate, represented by Y in the formula above.

(credit to wikipedia for the formula images)

Adjust Earnings Per Share

But intrinsic value shouldn’t be calculated based on a single 12 month period which is why I have the EPS automatically adjusted to a normalized number ignoring one time huge or depressed earnings based on 5 year or 10 year history depending on the company you are looking at.

Get Access to More Content
Enjoy what you're reading? Get instant access to our articles via email and receive bonus investing spreadsheets.

EPS is never really a good number on its own as it is highly prone to manipulation with modern accounting methods. Another reason why you have to always normalize EPS is because management will never understate earnings on purpose. While companies may follow accounting procedures which inflates earnings, they will never go out of their way to make it lower than it is.

Another variation of the formula will use the projected EPS but unless it is a pure growth stock with exponential growth like characteristics, the stock value will become absurdly high.

EPS by analysts are also always over optimistic, so by following Wall Street guidance, you’re starting off on the wrong foot.

Adjust Growth Rate

The drawback of the Benjamin Graham formula is that growth is a big element of the overall valuation.

You can change 8.5 to whatever you feel is the correct PE for a no growth company. Depending on your conservativeness, anything between 7 and 8.5 should be fine.

For the actual growth rate, if convenience is important, you could just use the analyst 5yr predictions from Yahoo or other sites, but for most value stocks that I search for, predictability is important so a regression of the historical EPS to project the following year is a method I like to use.

The “2 x G” however, is quite aggressive. So I’ve recently reduced the multiplier to 1.5 instead of 2.

Corporate Bond Rate

I currently have the stock value spreadsheet set up to use the 20 year A corporate rate which is just above 6%. This provides a slightly more conservative intrinsic value than the 20 year AAA or AA.

Final Adjusted Benjamin Graham Formula

So by making the adjustments, the new formula is now

Bejamin Graham Formula OSV

Testing the Formula

Testing this equation on Microsoft, the inputs are

  • Normalized EPS = $1.40
  • g = 12.6%
  • Y = 6.05%

which results in an Ben Graham intrinsic value of $29.10. Current price as of writing is $29.41.

Results look pretty good, but not all companies are as predictable or stable as MSFT so the stock valuation could be a coincidence.

A growing company DLB.

  • Normalized EPS = $2.1
  • g = 17%
  • Y = 6.05%
  • Intrinsic value = $53.56
  • Current price = $44.72

What about growth story AAPL?

  • Normalized EPS = $7.6
  • g = 18.6%
  • Y = 6.05%
  • Intrinsic value = $207.41 (much different to my dcf valuation of AAPL)
  • Current price = $199.91

The results aren’t all too bad but obviously, you will need to be careful of your inputs. And never forget margin of safety.

Disclosure

No positions at time of writing.

  • Ryan B

    Hi Jae, instead of using normalized EPS what about owner earnings per share?

  • Andrew

    Hey Jae, no matter how I plug in the numbers in the examples I cannot get the correct intrinsic value from the examples.

    For the MSFT valuation it should be V = [1.4 (7 + 1.5(12.6)) x 4.4]/6.05

    Please correct me if I am mistaken!

  • http://www.oldschoolvalue.com Jae Jun

    @ Ryan
    I never thought about trying it with owner earnings. I don’t see why it won’t work. Use the normalized owner earnings and use the owner earnings growth rate and plug it in the formula. I’m gonna try it right now and see what I get.

  • http://www.oldschoolvalue.com Jae Jun

    @ Andrew

    Keep in mind that the formula looks real simple but you need to expand it.

    If I expand the numerator it becomes

    4.4*EPS*8.5 + 4.4*EPS*2g

    then divide the whole thing by 6.05.

    In excel the formula is
    =1.4*(7+(1.5*12.6)*(4.4/6.05))

  • Andrew

    why did my last comment get deleted?

  • Andrew

    Jae, I plugged in the numbers to both of your equations and results are the same as what I have calculated, 26.37 and not 29.10.

  • http://www.oldschoolvalue.com Jae Jun

    Andrew,

    I think you’re making a mistake with the order of operations somewhere.

    Just enter “=1.4*(7+(1.5*12.6)*(4.4/6.05))” into excel and you will get the number.

    I didn’t delete any comments by the way.

  • Andrew

    Hi Jae, thanks for the clarification, I got the same number using 1.4*(7+(1.5*12.6)*(4.4/6.05)). Just wanted to point out V= [EPS*(7*1.5g)*4.4]/Y (the equation you have on top) is not the same as the formula you provided in the excel!

    Anyways really enjoy reading your blog keep up the good work!

  • http://www.oldschoolvalue.com Jae Jun

    Andrew,

    You’re right!
    I made the mistake and never re-checked it after all this time.

    Thanks for pointing it out. I’ll fix it and send it out in the next update.

  • David Ng

    hi jae, although i feel okay with your adjustments to the formula. but then intrinsically, you’re changing benjamin graham’s formula. as we all know, buffett is the most disciplined follower of graham. if you take a look at his recent BNI acquisition. buffett still uses graham’s formula to place a value on BNI. we get a value around $93 and buffett paid $100.

    when you adjust your formula. we get a value for BNI around $65. then would you be suggesting that buffett overpaid for BNI (which is not his usual practice)?

  • http://www.oldschoolvalue.com Jae Jun

    David,

    Based on my assumptions, Buffett wouldn’t use Graham’s formula as it depends heavily on EPS which is something Buffett has clearly expressed is not correct. Even if he decided to use his Owner earnings as the EPS, that still changed the formula.

    The formula is only guide. There is no right and wrong way, but for my investing, the standard Graham formula is not correct.

    BNI is a very different story and is much deeper than a valuation. Buffett bought it as an inflation protection investment as well as its hidden assets which is not shown on the balance sheet.

    So on paper, I think he overpaid, but in reality, he probably got a good deal. Also remember his See’s Candies purchase was not a cheap one at the time.

  • Luke

    Hi jae,

    just wanted to know if Grahams formula can be used for UK stocks?

    Great site by the way.

  • http://www.oldschoolvalue.com Jae Jun

    Luke,

    Yes the formula works for all companies

  • JMRojo82

    Good post. I have 3 questions.
    1) Does “The Intelligent Investor” explain the methodology behind the variables in the formula, specifically why was 2 used in 2g (ie – I understand 2 is modifying the PE ratio to reflect the growth rate, but what makes 2 the magic number to adjust the growth rate? or 1.5 for that matter)
    2) Why are we multiplying the percentages by 100 (ie 12% is 12 in your formula and not .12)?
    3) Can you explain the original equation is multiplied by 4.4%/y. I see your explanation above, but don’t follow the mathematical relationship.
    If all of this is covered in Grahm’s book, then just tell me to defer to the book.
    Thanks,
    -Rojo

  • MJ

    Actually Buffett ended up paying about $93/share for BNI if you include the 22% he bought on the open market before the buyout offer. Those shares were purchased at a cost basis of something like $75.

  • Michael

    Who are you?

  • Michael

    …Andrew, that is.

  • C

    I’d like to point out that the calculations on this page are incorrect.

    So instead of:
    =1,4*(7+(1,5*12,6)*(4,4/6,05))

    it should be:
    =1,4*(7+(1,5*12,6))*(4,4/6,05)

    See http://www.fool.com/portfolios/rulemaker/2001/rulemaker011031.htm for details.

  • Imran

    Dear Jae,
    At the outset, I would thank you to provide us with such a valuable source of investment information. I am hugely fascinated by your excel spreadsheet intrinsic value calculator. However, my problem is that I am in India and I do not know a database from where I could pull up the data nto your spreadsheet (after i buy it). Could you please somehow use your research and help me with this problem. Secondly, I have personally developed a Graham formula and DCF valuation worksheet, where my biggest problem is the calculation of growth rate. My question is that whether five years growth data of free cash flow would be enough to arrive at a meaningful value of the stock. Any more suggestions would be helpful. Thanks.

  • http://www.oldschoolvalue.com Jae Jun

    @ Imran,

    I get asked a lot about whether the spreadsheets will work outside of USA and the simple answer is no.

    As far as I know, there is no other country in the world that offers the level of transparency required by public companies as well as the vast amount of resources available by 3rd party sites.

    Regarding the growth rate calculation, it is very subjective but you wouldn’t want to use the FCF growth rate for the graham calculation because the Graham formula is based off earnings. You would have to use the EPS growth for that.

  • aku

    Do people use Ben Graham Method in real life to do stock valuations?

  • http://www.oldschoolvalue.com Jae Jun

    Yes sure do. It’s a decent method.

  • Sam Ho

    I see that you used normalized EPS here but estimated EPS in ur spreadsheet?

    which one do u prefer in what scenario? does it depend on Rsquare?

    Thank You

  • Sujal

    Hi, I liked your explanation. But can you help me to figure out equation for Indian market. I’m from india. In India, corporate bond is interest rate is around 9.5 to 10%. AAA bond yield will come around 11.5% so what should be my equation for calculating intrinsic value = (EPS * (7 + (1.5*G))*9.5)/11.

    Is it correct ? Please help me to solve this. And my modification is correct or still i should use either original or your modified formula ?

  • http://www.actioninvestmentmgt.com jalleninvest

    Graham added a warning to his discussion of this formula in The Intelligent Investor:

    “This material is supplied for illustrative purposes only, and because of the inescapable necessity in security analysis to project the future growth rate for most companies studied. Let the reader not be misled into thinking that such projections have any high degree of reliability or, conversely, that future prices can be counted on to behave accordingly as the prophecies are realized, surpassed, or disappointed.”

    Graham, Benjamin; Jason Zweig; Warren E. Buffett (2009-03-17). The Intelligent Investor, Rev. Ed (Kindle Locations 4359-4362). HarperCollins e-books. Kindle Edition.

  • Burak

    It is funny to see people here discussing a formula that wont help them. You can get every possible value for this formula. This formula is only usable if you have businnes experience and so know what factors are relevant for the growth rate. Believe me: 95% of you dont know how to use it correctly.
    In real this formula is only a product of a more useful formula that gives back the intrinsic value with a certainity of 100 percent.
    I dont know if Graham knew this other formula. I can imagine he did but he didnt tell. Why should he? Why should Warren Buffett tell you the core of his knowledge or the “moat” like he would say.
    If you want to learn this formula you must read read read, i give you 7 years, therein you will may be able to create this simple formula.
    Unfortunatelly i wont tell you, like Buffett wont tell you, too. This formula is the real “moat” that makes me one of the 5% winning, and the others 95% loosing and wasting their time with Graham´s formula, which give too much room for interpretation for 95% of people dont knowing which rate to use.
    I hope you see me one day next to the greatest investors. I hope you dont waste your time with this formulas. You should read day and night books about economics and businesses, like i did many years. There are no secrets, many years of reading can give you key information that you will never find on google, or in any formula book, or chats or sites like this.

  • http://www.oldschoolvalue.com Jae Jun

    I believe you mean to be helpful, but to me it just comes across as arrogant.
    There are a category of people in the world like Graham who just enjoy teaching and sharing without wanting anything in return. These people just have an abundant wealth of knowledge from all the reading they have done, and go out of their way to teach and share. How do I know? Because I know several of these people first hand.

    Just believing that reading will help you is useless. Without discussion and application, it’s nothing but wasted words. That’s the key.

  • Hieu

    How do you get the growth rate (g) ?

  • http://www.oldschoolvalue.com Jae Jun

    growth rate is calculated based on historical returns. If the growth rate seems incorrect, you also have the option of overriding it with your own value.

  • Steve

    Historical return means revenue or Net profit?

  • http://www.oldschoolvalue.com Jae Jun

    growth rate based on historical EPS values

  • Andy

    How do you calculate the normalized EPS?
    Average return on equity (ROE) form most recent full cycle * current book value per share?
    Can you Please give an example for your normalized EPS and data source?
    Thank you,
    Andy

  • okiwa

    1. Lease Offering Company (LOC) has issued a 5-years bond with par value of Rs. 1,000 at
    coupon of 11.8% per annum payable semi-annual. The bond was issued at discount and
    currently trading at Rs.865. For a risk averse, required rate of return is 13.5% for this bond.
    Credit Rated Agency (CRA) has recently rated this bond at BBB – moderate.
    2. Titanic Transportation has issued a 5-years bond at a coupon of 17% per annum payable semiannual.
    The bond with par value of Rs.1,000 is currently trading at Rs.1,080. For a risk taker,
    this bond has an opportunity cost of 14%. CRA has rated it at B – highly speculative.
    3. Saman Textile’s common stock is selling at Rs.88 per share in the stock market. The company
    has recently paid Rs.6 per share as dividend. The dividend is expected to grow at 7% for
    foreseeable future. For a rational investor, this share can be purchased at a cost of 14%.
    4. Abuzar Sugar’s dividend is expected to grow at 8% for foreseeable future and currently they are
    paying Rs.8.50 per share as dividend. The company is rated as a blue chip in the stock market.
    Currently the share is trading at Rs.100 each. A sharp Investors is ready to invest in this share at
    a require return of 16%.
    1. Calculate intrinsic value of the above securities

  • http://www.oldschoolvalue.com Jae Jun

    Hi okiwa,

    Do you own these companies and just want to see what the calculated value is?

  • Theodore Petrara

    Burak-
    Your response as to the ‘real’ formula was neither helpful nor generous of spirit. After spending the nummerous years applying and reading about these valuations, as you claim to have done, i should imagine that you would have already taken your rightful place at the ‘successful investor’ table. Maybe you have, and maybe not. Arriving at the table is one thing, staying there is quite another, and infinitely more difficult. i would suggest that to be a successful investor even your secret formula alone will not help you (or anyone else). You will need a few other items. I also suggest that this toolbox be backed up with healthy doses of generosity, kindness, and humility. Jae’s reply to you, for instance, was ‘generous’. Your note to him was not.

  • Alberto

    Hi Jae,

    Thank you for your article.

    May I ask you a question?

    Can you please post the url of yahoo website where you take the ”analyst 5yr predictions” for Microsoft?

    Thank you,
    Alberto

  • Casimir

    Hi, Why Benjamin choosen 2G and not 1.5G or 1G ? What mean 2 ?

  • http://www.oldschoolvalue.com Jae Jun

    2 x G was chosen because at that time, growth was much lower than today.

x
Get a FREE Mini Course on Valuation and Start Achieving Higher Stock Returns

Bonus: Receive Accompanying Investing Spreadsheets for Each Lesson