Deciphering the Graham Number: A Stock Valuation Metric
Graham Number: Explanation, Formula, Illustration, and Restrictions
The Graham Number, named after legendary value investor Benjamin Graham, serves as a measure to determine the upper limit a defensive investor should pay for a stock. This metric is derived from a company’s earnings per share (EPS) and book value per share (BVPS).
Calculating the Graham Number involves the square root of a multiplier that represents an ideal price-to-earnings (P/E) ratio of no more than 15x and a price-to-book (P/B) ratio of not over 1.5x (which totals to 22.5). In numerical terms, the calculation can be simplified as follows:
Graham Number = √(22.5 × EPS × BVPS)
Understanding the Concept
The Graham Number functions as a general test when attempting to identify undervalued stocks. By employing this metric, investors can make informed decisions on stocks that appear to be selling at attractive prices.
Any stock price below the Graham Number is considered undervalued, making it an attractive investment. On the other hand, if the current price surpasses the Graham Number, the stock may be overvalued, posing a potential risk.
A Deep Dive into the Formula
This calculation formula achieves its objective by taking a company’s earnings and asset valuation metrics and providing a standardized output for comparison purposes. The Graham Number formula uses the following variables:
- Earnings Per Share (EPS): a company’s net profit divided by the number of outstanding shares of its common stock
- Book Value Per Share (BVPS): the ratio of equity available to common shareholders divided by the number of outstanding shares
The Intricacies of the Graham Number and Fundamental Analysis
As a universally applicable metric, Graham’s Number is popular within the value investing community. Unlike digging into a company’s financials and earnings calls, this approach requires only the book value per share and the earnings per share to assess a stock's potential worth.
Fundamental analysis, which primarily focuses on key metrics and economic indicators, like revenues, earnings, and profit margins, serves as the foundation for determining a company's value.
Warren Buffett, a highly successful fundamental analyst and student of Benjamin Graham, often employs fundamental analysis in his investment strategies. This method of security analysis is generally understood to be the opposite of technical analysis.
The Limitations of the Graham Number
While the basic calculation for the Graham number does not account for other essential investment factors, such as management quality, major shareholders, and the competitive landscape, it still provides useful insights when analyzing potential investments.
Despite its limitations, the Graham number serves as a valuable tool for defensive investors who are more focused on stable, long-term value rather than short-term market fluctuations. Nevertheless, it’s essential to keep in mind that it doesn't account for growth expectations, which can be an important consideration when evaluating growth stocks.
In Non-Financial Terms: Graham Number for Children
In straightforward terms, Graham’s number is a simple way of calculating a stock’s real value, based on its quarterly profits and the value of its assets and liabilities. If the market price of a stock is lower than the Graham Number, the price is likely to rise.
Investment Advice and Background Information
Graham’s number offers a universal metric that can be consistently applied to companies in any industry. Investors who adhere to the value investing philosophy might find the Graham number indispensable for their investment strategies.
As one of the founding fathers of value investing, Benjamin Graham played a critical role in shaping the investment strategies of countless investors, including Warren Buffett, who has been widely recognized as "the Oracle of Omaha." Graham's philosophies emphasized a close examination of a company's financial statements to uncover undervalued opportunities. His book "The Interpretation of Financial Statements" is regarded as essential reading for value investors.
- For defensive investors, the Graham Number, a universal metric originated by Benjamin Graham, serves as a guide to determine the upper limit they should pay for a stock, employing the principles of technical analysis in finance.
- Employing the Graham Number formula, which uses variables such as Earnings Per Share (EPS) and Book Value Per Share (BVPS), can help investors identify undervalued stocks and make informed decisions on potential investments.
- In the world of financial business, the Graham Number is a popular tool among value investors, as it requires only the book value per share and the earnings per share for stock evaluation, bypassing the need for in-depth financial analysis.
- Although the Graham Number doesn't account for growth expectations, management quality, major shareholders, and the competitive landscape, it still provides valuable insights for those seeking stable, long-term value in their investments, much like initial coin offerings (ICOs) and Bitcoin mining operations in the defi space.
