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.

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 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 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.

Using the formula is straightforward. Once you calculate the Graham Number, you compare it to the stock's current market price.

1. 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.
2. 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.

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:

1. Graham Number = √ (22.5 x $3.50 x $30.00)
2. Graham Number = √ (2362.5)
3. 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.

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 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.