====== Graham Number ======
The Graham Number is a formula developed by the legendary investor and "Dean of Wall Street," [[Benjamin Graham]]. It serves as a handy, back-of-the-envelope calculation to estimate the theoretical [[intrinsic value]] of a stock. Think of it as a quick sanity check for investors looking for conservatively priced companies. The formula provides an upper price limit that a defensive investor should consider paying for a given stock. If the stock price is trading below its Graham Number, it's considered a candidate for further investigation, as it may be undervalued. The core idea is to find fundamentally sound businesses at a reasonable price, a central tenet of [[value investing]]. The calculation cleverly combines a company's earnings power with its asset value, providing a single, easy-to-interpret figure.
===== The Formula Unpacked =====
At its heart, the Graham Number is a simple mathematical expression. The formula is:
**Graham Number = Square Root of (22.5 x [[Earnings Per Share (EPS)]] x [[Book Value Per Share (BVPS)]])**
Let's break down what these components mean and why they were chosen.
==== The Magic Number: 22.5 ====
The number 22.5 isn't arbitrary; it's the product of two of Graham's key investment criteria for defensive investors:
  * A [[Price-to-Earnings (P/E) ratio]] should be no more than 15.
  * A [[Price-to-Book (P/B) ratio]] should be no more than 1.5.
Graham reasoned that multiplying these two maximums (15 x 1.5 = 22.5) created a reliable ceiling for a stock's valuation. By incorporating this constant, the formula automatically balances the relationship between price, earnings, and asset value. For example, a company with a very low P/B ratio could justify a higher P/E ratio, and vice-versa, as long as the combined product didn't exceed 22.5.
==== The Two Pillars: EPS and BVPS ====
The formula rests on two critical data points from a company's financial statements:
  * **Earnings Per Share (EPS):** This metric tells you how much profit a company generates for each outstanding share of its stock. It's a direct measure of a company's profitability and earning power.
  * **Book Value Per Share (BVPS):** This represents a company's net asset value ([[book value]]) on a per-share basis. It's a more conservative measure, calculated by taking a company's total assets and subtracting its intangible assets and liabilities. It gives you a sense of the tangible, physical value backing each share.
===== How to Use the Graham Number =====
Using the formula is straightforward. Once you calculate the Graham Number, you compare it to the stock's current market price.
  - **If the Market Price is //below// the Graham Number,** the stock is potentially undervalued and warrants a closer look. It suggests you can buy the company's earnings and assets at a discount.
  - **If the Market Price is //above// the Graham Number,** the stock is likely overvalued according to this specific metric, and a defensive investor should probably steer clear.
=== A Simple Example ===
Let's say you're looking at "Sturdy Manufacturing Inc.":
  * Its EPS is $3.50.
  * Its BVPS is $30.00.
  * Its current stock price is $75.00.
First, calculate the Graham Number:
  - Graham Number = √ (22.5 x $3.50 x $30.00)
  - Graham Number = √ (2362.5)
  - Graham Number = **$48.61**
In this case, the stock's current price of $75.00 is significantly //higher// than its Graham Number of $48.61. According to Graham's formula, this stock is overvalued, and you'd be paying too much for it.
===== A Word of Caution: Limitations in the Modern Market =====
While the Graham Number is a fantastic tool, it's not a magic bullet. It was developed in a different economic era, and investors must be aware of its limitations:
  * **Industry Bias:** The formula works best for stable, industrial-type companies with significant tangible assets. It's often too restrictive for modern technology or service-based companies, which have valuable [[intangible assets]] (like brand equity or software code) not fully captured by BVPS.
  * **Doesn't Work for All Companies:** The formula cannot be used if a company has negative earnings (a negative EPS), as you cannot take the square root of a negative number.
  * **A Blunt Instrument:** The Graham Number is a screening tool, not a complete valuation method. It doesn't account for a company's growth prospects, debt levels, or the quality of its management. It provides a number, but not the story behind it.
===== The Bottom Line =====
The Graham Number remains a timeless and valuable concept for today's investors. It’s a simple, conservative yardstick that instills discipline and helps you quickly identify potentially cheap stocks while enforcing a crucial [[margin of safety]]. While it shouldn't be the only tool in your analytical toolbox, it's an excellent starting point for any investor serious about [[fundamental analysis]] and finding true, durable value in the market.