- Why Graham Created This Valuation Formula
- Quick Filtering Process Explained
- The Ben Graham Number
- How to Put into Practice
- The 7 Filters to Use the Graham Value
- Important Notes About the Graham Value
- My Recommendation on the Ben Graham Number and Formula?
- Looking for a Way to Use the Graham Formula and other Valuation Methods?
- Further Reading
I’ve talked about valuing stocks with the Ben Graham Formula a lot on old school value and how to use it properly.
With valuation, taking things into context is very important. If you aren’t careful, it’s easy to think that everything is a nail when you have a hammer.
With the OSV Stock Analyzer, the Graham method gets a lot of attention because
- it’s easy to understand
- it’s easy to use
- it’s easy to adjust for different scenarios
Here’ the formula that I’m talking about.
But with the Ben Graham formula in the stock analysis software, instead of using 1.5 x growth, I’ve adjusted it down to simply 1x growth.
After calculating and valuing hundreds of companies with the formula and testing its robustness, I’ve concluded that using 1x is the best way to go.
Why Ben Graham Created This Valuation Formula
It’s no secret that Graham was a cheap stock investor who bought baskets of stocks instead of concentrating.
His approach was much more mechanical.
His first criteria was cheapness and that was usually enough. But after going through countless number of stocks, here’s what he says.
Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the valuation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations. – The Intelligent Investor
In 3 short bullets, he used the formula himself for;
- Estimate of intrinsic value
It’s definitely not the golden rule and it’s not something he went with blindly, but it’s a good approximation and a good starting point to use in your investigation.
After all, Buffett says that
It is better to be approximately right, than precisely wrong.
The great thing about the Graham formula is that it can be applied to any company with a positive EPS.
Although EPS is not ideal, when you are trying to study and value businesses with negative FCF, weak balance sheet and low EBIT, you only have EPS and past or expected growth to work with.
Relative valuation such as PE multiples compared to peers isn’t a method that I use often.
Relative multiples don’t account for the market value. In a hot market, everything can look expensive, while a bear market can make things look cheap.
Quick Filtering Process Explained
I have a process of valuing stocks.
If you’re not sure about your own, here’s a guide I made a while back that you can reference and use to tweak your own.
The way I go about doing things is much different now.
The first thing I do is to simply calculate a quick and dirty valuation of a company.
Graham’s formula obviously helps a lot with this, but I have about 8 valuation tools to choose from depending on the type of company I’m looking at.
The good thing about having a lot of valuation models in your toolbox is that you’re not stuck trying to fit a square into a circle.
Then with all this newfound knowledge based on the financials, I can do a cleaner valuation.
If the numbers look good, then it’s time to check everything by going through filings, conference calls etc to find problems with the company.
That’s my short hand method.
Graham doesn’t go into exact details of his complete short hand method, but his formulas and checklists were a big part of them.
But one number that I haven’t written about is the Ben Graham Number, another conservative way to look at stock values.
The Ben Graham Number
Using the EPS and book value, the Graham Number is a value for the upper range of what a defensive investor should pay for a stock. – investopedia
Before getting into the meat of the formula, you can use tangible book value to make the number more reflective of tangible assets instead of goodwill and intangibles.
The formula you see at the top is the final form.
Again, Graham was a cheap stock investor so he didn’t want to pay too much for anything.
So he created a rule of thumb so that he didn’t buy stocks with a PE above 15 and a P/B greater than 1.5.
Guessing wildly, in today’s terms it could mean something like staying away from stocks with a PE above 25 and P/B greater than 3.
A more accurate method would be to go back and calculate how inflation affects the PE from 1973 to today.