Graham number: Meaning, Criticisms & Real-World Uses

What Is Graham Number?

The Graham Number is a financial metric used in value investing to estimate the maximum fair market price that a defensive investor should pay for a common stock. It represents a conservative valuation approach designed to identify stocks that meet Benjamin Graham’s stringent criteria for safety and value. This number helps investors determine if a stock is trading at a reasonable price, considering its earnings per share (EPS) and book value per share. The Graham Number is a simplified application of Graham's investment philosophy, aiming to provide a clear threshold above which a stock might be considered overvalued for a conservative purchase.

History and Origin

The Graham Number is derived from the investment principles espoused by Benjamin Graham, often called the "father of value investing" and mentor to Warren Buffett. Graham introduced these concepts in his seminal work, The Intelligent Investor, first published in 1949.,, ¹⁴I¹³n this book, Graham emphasized the importance of rigorous fundamental analysis and purchasing stocks at a significant discount to their underlying worth, thereby incorporating a margin of safety. His philosophy sought to protect investors from substantial errors and encourage long-term strategies. T¹²he Graham Number itself is a simplification, aiming to quantify one aspect of Graham's criteria for a sound investment: that the product of a company's price-to-earnings ratio and price-to-book ratio should not exceed 22.5. This limitation was established to prevent investors from overpaying for either earnings or assets, thereby aligning with his defensive investing approach. Warren Buffett, a prominent advocate of Graham’s principles, further popularized value investing through his successful application of these strategies.,,

¹¹##¹⁰ Key Takeaways

The Graham Number provides a calculated maximum price a defensive investor should pay for a stock.
It is based on a company's earnings per share and book value per share.
The formula reflects Benjamin Graham's conservative approach to valuation, emphasizing safety.
Stocks trading below their Graham Number may be considered undervalued by value investors.
It serves as a quick screening tool for potential investment opportunities that align with Graham's principles.

Formula and Calculation

The Graham Number is calculated using the following formula:

\text{Graham Number} = \sqrt{22.5 \times \text{Earnings Per Share} \times \text{Book Value Per Share}}

Where:

Earnings Per Share (EPS): A company's net profit divided by the total number of its outstanding common stock.
Book Value Per Share (BVPS): A company's total assets minus its total liabilities, divided by the number of outstanding shares. This represents the theoretical value per share if the company were to be liquidated.
22.5: This constant is derived from Graham's criteria that the price-to-earnings ratio should not exceed 15 and the price-to-book ratio should not exceed 1.5. The product of these two limits (15 x 1.5) is 22.5.

Interpreting the Graham Number

The Graham Number provides a theoretical ceiling for a stock's price, above which a defensive investor would generally avoid purchasing the shares. If a stock's current market price is below its calculated Graham Number, it suggests that the stock could be undervalued according to Graham's criteria. Conversely, if the stock's price is significantly above the Graham Number, it indicates that the stock might be overvalued, potentially offering a lower margin of safety.

Investors typically use the Graham Number as a screening tool to identify potential candidates for further research within the framework of stock valuation. It helps in quickly filtering out stocks that do not meet the initial criteria for a conservative investment, guiding the focus towards companies that appear to offer a reasonable blend of earnings power and asset backing relative to their price.

Hypothetical Example

Consider a hypothetical company, "DiversiCorp," with the following financial data:

Earnings Per Share (EPS) = $5.00
Book Value Per Share (BVPS) = $40.00

To calculate the Graham Number for DiversiCorp:

\text{Graham Number} = \sqrt{22.5 \times 5.00 \times 40.00}

\text{Graham Number} = \sqrt{22.5 \times 200}

\text{Graham Number} = \sqrt{4500}

\text{Graham Number} \approx 67.08

If DiversiCorp's current share price is $55.00, it is trading below its Graham Number of approximately $67.08. This suggests that, from a conservative value investing perspective, DiversiCorp might be a potentially attractive investment, as its price offers a margin of safety compared to this calculated intrinsic value. This simple scenario illustrates how the Graham Number serves as a quick gauge for preliminary investment consideration before delving into a deeper fundamental analysis.

Practical Applications

The Graham Number is primarily used by investors who adhere to the principles of value investing. It serves as a preliminary screening tool to filter stocks that are potentially undervalued and offer a margin of safety. For instance, an investor might use the Graham Number to quickly assess whether a company's market price is reasonable before conducting a more thorough fundamental analysis.

It helps in identifying companies with solid financials that are not overly speculative. Investors can find historical financial data, including earnings per share and book value per share, from various financial data providers to perform this calculation.,,,,⁹ ⁸B⁷y ⁶focusing on these core metrics, the Graham Number guides investors toward businesses that possess a tangible asset base and consistent earnings, aligning with a defensive investing strategy. It helps in the initial stages of asset allocation when considering individual stock picks.

Limitations and Criticisms

While the Graham Number provides a straightforward approach to stock valuation, it has several limitations. It is a highly simplified metric and does not account for many qualitative factors crucial to a company's long-term success, such as management quality, competitive advantages, industry trends, or brand strength. It is particularly less effective for growth stocks that may have high growth potential but low current earnings or book value.

Critics also point out that the fixed multipliers (15 for P/E and 1.5 for P/B) in the underlying calculation are arbitrary and may not be relevant in all economic conditions. A rapidly changing economy can significantly impact what constitutes a "safe" or "fair" valuation, as opportunity costs and market rates can fluctuate.,,,,⁵ ⁴T³h²e¹ Graham Number also does not consider a company's debt levels, future earnings potential beyond current EPS, or dividend yield, all of which can influence a stock's true worth and an investor's capital appreciation potential. Relying solely on the Graham Number can lead to overlooking strong companies that appear "overvalued" by this single metric but possess significant underlying value from other perspectives.

Graham Number vs. Intrinsic Value

The Graham Number is a specific formulaic approximation of a stock's value, while intrinsic value is a broader concept representing the true, underlying worth of an asset, independent of its market price. The Graham Number aims to provide a quick, conservative estimate of intrinsic value based on specific historical financial data points (earnings and book value), adhering strictly to Benjamin Graham's defensive investment guidelines.

In contrast, calculating intrinsic value often involves a more comprehensive stock valuation process, such as discounted cash flow (DCF) analysis, which projects future cash flows and discounts them back to the present. While the Graham Number provides a numerical threshold, intrinsic value is a more holistic concept that considers a wider range of qualitative and quantitative factors, including a company's competitive landscape, growth prospects, management quality, and industry outlook. Confusion often arises because the Graham Number attempts to quantify a "fair" value, which is a component of understanding intrinsic worth. However, the Graham Number is merely one tool among many that can be used to approximate intrinsic value, and it adheres to a highly conservative framework.

FAQs

Is the Graham Number still relevant in today's market?

While the Graham Number originated decades ago, its underlying principles of conservative stock valuation remain relevant for defensive investors. It serves as a useful starting point for screening stocks that align with a value-oriented approach, though it should be used in conjunction with more modern analytical tools and qualitative assessments.

What does it mean if a stock's price is above its Graham Number?

If a stock's market price is above its calculated Graham Number, it suggests that the stock is considered overvalued according to Benjamin Graham's conservative criteria. A defensive investor might then either avoid the stock or seek a more significant margin of safety.

Can the Graham Number be applied to all types of companies?

The Graham Number is most suitable for stable, mature companies with consistent earnings and significant book value. It is generally less applicable to growth stocks, which often prioritize reinvestment over current earnings and may have higher valuations based on future potential rather than present assets or profits.