The Graham number is a formula based on the work of the pioneering investment analyst Benjamin Graham.
The Graham number is a method developed for defensive investors. It evaluates a stock’s intrinsic value by calculating the value of the stock based on its earnings and book value. If the resulting value is higher than the current selling price then the stock is considered to be under valued. The formula is the square root of 22.5 times the multiplied value of the company’s earnings per share (EPS) and book value per share (BVPS).
To apply this method, two conditions must be met:
- The average Price to Earning ratio (P/E) for past 3 years should not be > 15.
- The Price to Book ratio (P/B) should not be > 1.5.
Financial Stocks:
Note that he did not believe this formula provided a valid criteria for selecting financial stocks like banks and insurance companies, and also does not apply to asset-light
companies with more than 10% growth rate (which I believe would apply to most high-tech companies and other startups).
Other criteria Graham saw as essential to a defensive approach to stock selection:
- Current assets should be at least twice current liabilities.
- Long-term debt should not exceed the net current assets.
- Positive earnings in each of the past 10 years.
- Uninterrupted dividends for at least the past 20 years.
- A minimum increase of at least 33% in EPS in the past 10 years.
Earnings vs. Owner Earnings
Owner earnings rather than the stated earnings tell us the amount of value the company is creating and how much is flowing back to shareholders.
Owner earnings equal:
- reported earnings
- + depreciation & amortization
- +/- other non-cash charges
- – average annual maintenance capital expenditures (Capex)
- +/- changes in working capital.
“An intelligent investor is a realist who sells to optimists and buys from pessimists.” – Benjamin Graham.
