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What Is the Graham Number?
Let me explain the Graham number to you directly—it's a valuation metric I use to figure out the maximum price you should pay for a stock if you're a defensive investor. You wouldn't pay more than this number. According to the theory, if a stock's price is below the Graham number, it's undervalued and might be worth your investment. I derive it from the company's earnings per share (EPS) and book value per share (BVPS).
Key Takeaways
- The Graham number was created by legendary value investor Benjamin Graham.
- The number is arrived at using a company's earnings and book value, both on a per-share basis.
- Graham recommended that the P/E ratio multiplied by the price-to-book value ratio be no more than 22.5.
- He also intended that the number be used with other stock selection criteria, not on its own.
Understanding the Graham Number: Formula and Calculation
The Graham number is named after Benjamin Graham, the father of value investing. You can use it as a general test for intrinsic value when you're looking for stocks selling at an attractive price. The figure of 22.5 in the calculation comes from Graham's belief that the current price shouldn't exceed 15 times the average earnings for the previous three years, nor more than 1.5 times the latest reported book value. Multiplying a P/E ratio of 15 by a price-to-book ratio of 1.5 gives you 22.5. Graham stated explicitly that the product of the multiplier times the price-to-book ratio should not exceed 22.5.
You calculate the Graham number as the square root of 22.5 times earnings per share times book value per share. Earnings per share (EPS) is the company's net profit divided by outstanding shares—I recommend using the average of the past three years' EPS to avoid manipulation. Book value per share (BVPS) is the equity available to common shareholders divided by outstanding shares, representing the minimum value of the company's equity per share.
Fast Fact
While Graham felt the current price should not be more than 1.5 times the last reported book value, a P/E below 15 could justify a higher price-to-book ratio.
Example of the Graham Number
Take company ABC with earnings per share of $1.50 and book value per share of $10—the Graham number comes out to 18.37. You get that by taking the square root of 22.5 times 1.5 times 10. So, as a value investor, you should pay no more than $18.37 per share for ABC. If it's priced at $16, it looks attractive; at $19, you'd avoid it.
Limitations of the Graham Number
The Graham number calculation omits many fundamental characteristics that make a good investment, such as management quality, major shareholders, industry characteristics, and the competitive landscape. For stocks, fundamental analysis determines essential value by focusing on key metrics and economic indicators like revenues, earnings, industry cycle position, return on equity (ROE), and profit margins. This analysis relies on a company’s financial statements. Warren Buffett, a student and employee of Benjamin Graham, famously succeeded with fundamental analysis. It's considered the opposite of technical analysis.
Explain Like I'm Five
Graham's number is a simple way to measure a stock's real value based on the company's earnings and the value of its assets minus liabilities. If the market price is lower than this number, the price is likely to go up. It's popular among value investors because it gives a straightforward metric applicable to any industry. However, you should consider it alongside other criteria, not rely on it alone.
What Is a Good Graham's Number?
Graham's number always gives you a maximum stock price based on EPS and BVPS. Any stock price below that figure could signal a good buy for a value investor.
How Does the Graham Number Work in Value Investing?
The Graham number normalizes a company's per-share metrics using recommended limits for value investors: 15x P/E and 1.5x P/B.
Who Was Benjamin Graham?
Benjamin Graham is one of the founding fathers of value investing and mentored figures like Warren Buffett. His philosophy involved examining financial statements closely to find undervalued opportunities. His book 'The Interpretation of Financial Statements' is foundational for value investing.
The Bottom Line
The Graham number measures a stock's fundamental value using EPS and BVPS. It sets the highest price a defensive investor should pay, suggesting that prices below it indicate undervaluation and potential worth. Correction—March 21, 2024: This has been corrected to state Graham's belief that the price-to-book ratio should not exceed 1.5x.
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