What You’ll Learn
- How to value stocks using the Graham Formula
- Why Graham created this valuation
- The pros and cons of the Graham Formula
- Real examples using the Graham Formula to value stocks
For the rest of the series, be sure to check out the following links.
Stock Valuation Series
For other posts in the series, follow the links below.
- How to value a stock using the DCF Method
- How to value a stock using the Reverse DCF
- How to value a stock using Earnings Power Value
In this article, we’ll go through how to value a stock using the Benjamin Graham Formula.
Stock Valuation Concepts
Let’s start with the two most important concepts on how to value stocks.
Key Concept #1: Stock valuation is an art.
Give 5 people a paintbrush and they will paint different things.
The paintbrush, canvas, and paints are tools and are the equivalent of the quantitative side of valuation.
The strokes, the colors, and the technique that make the final image are the qualitative side of stock valuation.
When you try to value stocks, it comes down to interpreting the numbers on hand, then thinking forward and coming up with a narrative of what the company is trying to achieve.
Put those together and you have just valued a stock.
Stock Valuation = Past and Current Numbers + Future Narrative
Key Concept #2: Stock Valuation is a range, not an absolute.
With the examples I provide today, it’s important to understand that the final stock value will vary based on your assumptions.
Instead of trying to pinpoint one number, the art and science behind the concept of determining how to value stocks is to come up with a range of values.
Come up with a narrative for the possible downside of the company.
Come up with the narrative of the possible upside of the company.
Perform your valuation calculations using these scenarios and you will have a lower and upper range to work with. The fair value will lie inside that range somewhere.
Keep these two key points in mind as you see how to value stocks using the Ben Graham Formula.
Benjamin Graham Formula for Stock Valuation
The second method I use to value a stock is with Benjamin Graham’s formula from The Intelligent Investor.
In case you’re not familiar with Ben Graham, he’s widely recognized as the father of value investing. He wrote the books on value investing, Security Analysis and The Intelligent Investor. He employed and mentored Warren Buffett and taught for years at UCLA.
With the extremely popular free Ben Graham stock spreadsheet I offer, the stock valuation method deserves a closer look.
Original Benjamin Graham Value Formula
The original formula from Security Analysis is
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.
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 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 AA corporate bond rate, represented by Y in the formula above.
(credit to wikipedia for the formula images)
Adjusted EPS in the Graham Formula
Before we go deep into the Graham Formula, click on the image below to get the best free investment checklist and more investment resources to load up your valuation arsenal.
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 a 5-year or 10-year history, depending on the company you are looking at.
EPS is never really a good number on its own as it is highly prone to manipulation — either upwards to make the company look more profitable or downwards to reduce taxes — with modern accounting methods.
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.
Adjusted Growth Rate for Today’s EnvironmentAdjust Growth Rate for Today’s Environment
The drawback of Benjamin Graham’s valuation 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 how conservative you are, 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 Old School Value, 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 instead of 2. You’ll see why in the examples below.
Corporate Bond Rate
Final Adjusted Benjamin Graham Formula
So by making the adjustments, the new formula is now
Testing the Adjusted Graham Investment Formula
Let’s test this across several different companies and industries.
Alphabet Graham Formula Example
- EPS = 34.47
- g = 15.8%
- Y = 3.56%
The resulting Graham formula gives a value of $971.36
An important point to keep in mind is that when Graham provided this equation, it was to simulate a growth stock based on the concepts of value investing.
Facebook Graham Formula Example
Let’s look at Facebook (FB).
- EPS =4.14
- g = 29.4%
- Y = 3.56%
The intrinsic value comes out to $186.29.
If I used the original Graham Formula, this is what Facebook would look like.
You can see the big difference.
My adjusted version of no growth PE of 7 and 1xg compared to the original version of 8.5 and 2xg.
What this shows is that:
- The original Graham formula is aggressive
- It should be considered as the upper range
- It needs to be put into today’s context
There was no Facebook, Microsoft, or Google back in Graham’s time.
High growth companies didn’t achieve 30, 40, or 100% growth like some do today.
Caterpillar Graham Formula Example
On the other end of the spectrum, here’s the calculation for Caterpillar (CAT).
- EPS is 3.26
- The expected growth rate is 8.6%
- Corp rate is 3.56%
Additionally, based on the current price and if you reverse engineer Graham’s Formula, it tells you that the market is expecting 17.57% growth from the current price.
The actual forward-looking growth is much lower at 8.6%.
Thus, Graham’s valuation formula comes out to $62.86 with a zero margin of safety.
Ben Graham offered a very simple formula to calculate the intrinsic value of a growth stock. It can be applied to other sectors and industries, but you must put it into today’s context by adjusting the original formula.
Always practice margin of safety investing as well as understanding that valuation is finding a range of numbers. There is no such thing as an absolute range. Consider the Graham Formula to be the upper end of the valuation range.
No positions at time of writing.