Intrinsic Value Formula (IVF)

The Intrinsic Value Formula (also known as the 'Graham Number' or 'Benjamin Graham Formula') is a simple equation developed by the father of value investing, Benjamin Graham, to quickly estimate a company's intrinsic value. Think of it as a financial “rule of thumb” or a back-of-the-envelope calculation designed to give you a rough idea of what a business is fundamentally worth, separate from the often-fickle moods of the stock market. The goal isn't to find a magic number that is 100% accurate, but rather to provide a starting point for deeper research. By comparing the calculated intrinsic value to the current market price, an investor can quickly gauge whether a stock might be trading at a bargain or if it's dangerously overpriced. This simple yet powerful concept lies at the heart of Graham's investment philosophy: determine what a business is worth, and then pay a lot less for it.

Graham's formula wasn't set in stone; he even tweaked it himself to adapt to changing economic conditions. Understanding both versions gives us a great insight into how fundamental factors influence a company's value.

In his book Security Analysis, Graham first proposed this elegant equation: Intrinsic Value = Earnings Per Share x (8.5 + 2g) Let's break down the components:

• Earnings Per Share (EPS): This is the company's profit divided by the number of outstanding shares, usually taken from the trailing twelve months (TTM). It’s the engine of the formula.
• 8.5: This was Graham's baseline P/E Ratio for a company with zero growth. He considered this a fair price to pay for a stable business that wasn't expected to expand.
• 2g: This is the engine's turbocharger. The 'g' represents the estimated annual earnings growth rate for the next 7 to 10 years. Graham multiplied it by 2 to give extra weight to growth, but he was always extremely cautious about using high growth projections.

Graham later recognized a major flaw in his original formula: it didn't account for prevailing interest rates. If you can get a high, safe return from bonds, you should demand a higher return (and thus pay a lower price) for a riskier stock. To fix this, he introduced a revised formula in his book The Intelligent Investor: Intrinsic Value = (EPS x (8.5 + 2g) x 4.4) / Y The new ingredients are:

• 4.4: This was the average yield of high-grade U.S. AAA corporate bonds in the early 1960s, which Graham used as his risk-free benchmark.
• Y: This is the current yield on AAA corporate bonds.

This revision brilliantly connects the stock's valuation to the broader economic environment. If current bond yields (Y) are high (say, 8.8%), the formula's divisor is larger, resulting in a lower intrinsic value for the stock. This makes perfect sense—why take the risk of owning a stock if bonds are offering fantastic returns? Conversely, when bond yields are low, the intrinsic value estimate for the stock goes up.

Using this formula is part art, part science. It’s a powerful screening tool, but it's no crystal ball.

The IVF is best used as a quick filter. You can run it on a list of stocks to see which ones pop up as potentially undervalued. If the formula spits out a value that is significantly higher than the current stock price, it’s a signal that the company might be worth investigating further. It is not a signal to immediately buy the stock. It’s the beginning of your homework, not the end.

The most subjective and easily manipulated variable in the formula is 'g', the growth rate. A slight change in your growth assumption can lead to a massive change in the final intrinsic value. A true value investor, in the spirit of Graham, should be deeply conservative here.

• Be Realistic: Don't plug in the heroic growth rates you hear from company management or TV pundits. Look at the company's historical growth, the industry's prospects, and the overall economy.
• Be Conservative: When in doubt, use a lower number. It's far better to underestimate the value and miss a small opportunity than to overestimate it and suffer a large loss. For stable, mature companies, a 'g' of 2-5% is often a sensible starting point.

This is where the IVF truly shines for a value investor. The entire point of calculating intrinsic value is to then apply a Margin of Safety. This principle, which Graham called the “central concept of investment,” means buying a stock for a price significantly below your estimate of its intrinsic value. For example, if you use the IVF and calculate a company's intrinsic value to be $100 per share, you wouldn't buy it at $95. That's too close for comfort. A value investor would wait until the price drops to, say, $60 or $70. This 30-40% discount provides a crucial buffer. If your growth estimate was too optimistic, if the company hits a rough patch, or if you just made a mistake, the margin of safety protects your capital from a permanent loss.

Is a formula from the 1970s still relevant today? Yes, but with major caveats.

• Simplicity: It’s easy to understand and calculate.
• Discipline: It forces you to think about the fundamental drivers of value: earnings, growth, and interest rates.
• Objectivity: It provides a numerical anchor that helps you resist the emotional pull of market hype.

• Oversimplified: It ignores many critical factors, such as debt levels, the quality of management, a company's competitive advantage (moat), and free cash flow.
• Industry-Specific: The formula works best for stable, predictable, mature businesses. It is largely useless for tech startups, cyclical companies, or businesses with no current earnings.
• Sensitive to Inputs: As discussed, the output is highly dependent on your 'g' and 'Y' assumptions. Garbage in, garbage out.

Ultimately, the Intrinsic Value Formula is a timeless piece of investment wisdom. It’s not a magic answer, but rather a fantastic tool for framing your thinking, screening for opportunities, and instilling the discipline that is the hallmark of a successful value investor.