Valuation Series 1: The Graham Formula

Valuation is arguably the most important question for students and practitioners of value investing. Acurate valuation requires specialized expertise and prohibitive resources for information gathering and analysis.

Benjamin Graham, one of the founding fathers of value investing, provided average investors with effective and easy-to-operate methods of stock valuation. His valuation methods can be divided into two types: the first type estimates a company’s worth by focusing on its earnings and future growth; the other type has a more pessimistic assumption and focuses more on the survivability and liquidity value of a company.

Despite different perspectives, both types of valuation methods share the same goal: create sufficient margin of safety for defensive investment. In this article, I will focus on the earning- and growth-based valuation method: the Graham formula.

Ben Graham
Ben Graham

The Ben Graham Formula

In his classic The Intelligent Investor, Graham developed a shorthand formula for estimating the intrinsic value of a stock:

\[Intrinsic\ Value = EPS \times (8.2 + 2g) \]

In the revised book in 1974, he updated the formula:

\[ Intrinsic\ Value = \frac {EPS \times (8.5 + 2g) \times 4.4}{Y} \]

Formula Components

In the formulas above, EPS is earnings per share of a stock, 8.2 (or 8.5 in the updated formula) is the price/earnings ratio of a stock with no growth at that time, g is the estimated future growth rate of the company, 4.4 is the yield of AAA corporate bond at that time, and Y is the current AAA corporate bond yield. It should be noted that, since the models were developed long time ago, some analysts suggest to lower the price/earnings ratio (between 7 and 8) to better reflect the contemporary market environment.

EPS

EPS of a stock is one of the key financial statistics to investors. Platforms such as Yahoo Finance, Google finance, and other trading platforms contain this information for nearly all stocks. If EPS data is not readily available, then it can be easily calculated with information from a company’s financial statements and the following formula.

\[Earnings\ per\ Share = \frac {Earnings}{Outstanding\ Shares} \]

Earnings (AKA, net income or profit) can be found in the bottom line of a company’s income statement (alledgedly, this is origin of the phrase “the bottom line”).

Below is the income statement of GIII (Table 1). As you can see, the company had losses (negative net income or earnings) in the last two quarters.

Quarterly Income Statement of GIII
Table 1. Quarterly Income Statement of GIII

It should be noted that public companies listed in the US are required to file financial statements following the Generally Accepted Accounting Principles (GAAP) so that investors can easily compare standardized statements of different companies.

However, since companies differ in businesses and operation, many also publish their own version of statements (non-GAAP), which gives management more freedom in reporting the financial condition of the company. The non-GAAP statements is a double-bladed sword in that they could more accurately reflect the company’s financial condition or overplay the company’s strengths and downplay its weakness).

Outstanding Shares

The number of outstanding shares refers to the number of common shares that are owned by the shareholders of a company. This information can be found in the company’s balance sheet.

Quarterly Balance Sheet of GIII
Table 2. Quarterly Balance Sheet of GIII

So, to calculate the EPS of GIII in the third quarter of 2020, we insert the values of earnings and outstanding shares in the formula :

\[ \frac {-15,000,000}{48,359,000} = -0.31 \]

In practice, businesses or industries may be subjected to seasonal fluctuation (e.g. retailors tend to have higher earnings in the third and fourth quarter of a year), so quarterly earnings may not represent the company’s overall profitability.

In order to mitigate such inaccuracy, analysts often calculate EPS Trailing Twelve Months (TTM).

The difference between EPS and EPS TTM is that the latter uses total earnings of a company in the past 12 months to be divided by the (average) number of outstanding shares during the same period of time.

Some analysts would trail the earnings even further back in history (e.g. 5 or 10 years back) to minimize the impact of business cycle or short term market fluctuation on the company profitability.

Future Growth Rate

Most often, the growth rate of earnings or EPS is used to measure a company’s growth. After all, the purpose of a company is to make profit. However, for industries or companies that cannot make profit immediately, such as technology and e-commerce, growth in income (AKA sales, revenue) can be an alternative measurement.

Forecasting future growth without a crystal ball is difficult. Moreover, the further into the future we try to estimate, the less accurate our estimates are. Often, future estimates are extrapolated from historical growth rate (past 1 year, 5 years, or 10 years).

To calculate growth rate of earnings, for instance, record the earnings data in quarterly or annual income statement. Then, apply the following formula for a growth rate in percentage:

\[Growth\ Rate = (\frac {End\ Value}{Start\ Value} – 1) \times 100 \]

Successes and Limitations of the Graham Formula

The Graham formula gives investors a quick way to estimate the intrinsic value of a stock. If a stock’s market price per share is lower than its estimated intrinsic value, then the stock is considered undervalued. Academic study like this one shows that the formula still can provide investors long-term better-than-market returns in today’s US and international stock markets.

With that said, valuation is more of an art than science. Even Graham himself also acknowledged the inaccuracy of his model in his book. However fancy or complicated a model is, there is always a margin or error in our estimation. To minimize the chances of inaccurate valuation, we could apply a discount on the estimated intrinsic value to compare with the market price.

For example, if a stock has an estimated intrinsic value of $100 per share. To be safe, we apply a 25% (it number is arbitrary, and is up to you to decide depending on how much risk you can take) discount on the estimation, which lowers the valuation to $75.

Now, the stock is considered undervalued if its market price is lower than $75 not $100. In other words, applying discount would raise the bar for being an undervalued stock and consequently makes our investment less risky.

Another caveat is that being undervalued alone is not enough for us to own part of the company. The company needs to be able to increase earnings in the long term. The Graham formula relies a lot on how well investors can forecast future growth. Assuming a company’s past performance can predict its future performance is one of dangerous mistakes investors can make. For instance, many physical retail stores may have had great historical performance, but they are and will be increasingly overshadowed by the booming e-commerce companies such as Amazon. Companies without long-term capability to increase earnings, however undervalued, are not good investment.

Besides long-term profitability, a company must be able to survive short-term market fluctuations (mainly market downturns). Without the ability to survive the short term, long term profitability is just wishful thinking.

The world has taught us, profitable companies don’t always survive the market. For example, many reputable and profitable companies have filed bankruptcy during the COVID-19 pandemic (here is an incomplete list of these companies) due to poor management in their debt structures.

Fortunately, Graham also developed another valuation method that focuses on survivability: the Net-Net approach. I will cover Net-Net in another post.


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