What is Graham Number?

Key Highlights

• A Graham number is a measure of the maximum price that an investor should be willing to pay for one stock.
• It was developed by one of the most famous value investors, Benjamin Graham.
• The value is estimated by accounting for the company's earnings and book value per share.

What is the Graham Number in the Stock Market?

A helpful tool for defensive investors is the Graham number. A person who's willing to invest in the stock market is a defensive investor. In discussing the use of this method, any company, regardless of its size or industry, is effectively provided with a maximum stock price. This method will allow investors to find some of the best stocks at low prices. It's because Graham's number reveals the undervaluation of stocks. In addition, this valuation allows for purchasing undervalued stocks at a lower price.

Graham Number Formula

To calculate the fundamental stock value, use the given formula.

22.5× (Earnings Per Share) × (Book Value Per Share)

• Earnings Per Share (EPS) = Net Income / Shares Outstanding

• Book Value Per Share (BVPS) = Shareholder’s Equity / Shares Outstanding

• For the application of the Graham Number, there are a number of mandatory conditions: The EPS multiple, 15, used in the formula, represents the price-to-earnings ratio that cannot be higher than 15 in any case. This formula is not applicable if the company's P&E ratio is more than 15 %.

• Meanwhile, the BVPS multiple of 1.5 is a price-to-book ratio. The ratio between the P and B should be less than 1.5. This stock valuation tool cannot be used to calculate the company's stocks if they are above the P&B ratio limit.

Example of Graham Number

Ms A wants to buy the shares of ABC Co. Ltd. She is too busy as a full-time working mother to examine the company's finances in detail. She decides that, as a defensive investor, she will use the Graham number in order to judge whether ABC Co. Ltd's stock is worth buying. The company made an income of INR 40,00,000 for the year. The shareholders' equity stands at INR 600,000, and there are 500,000 shares outstanding. That's how ABC Company Ltd.'s Graham number is calculated by Miss A.

Earnings Per Share = Net income ÷ No. Of outstanding shares

• Earnings Per Share = 40,00,000 ÷ 5,00,000
• The profit per share is INR 8.

Book Value Per Share = Shareholder's equity ÷ No. Of shares outstanding

• Book Value Per Share = 6,00,000 ÷ 5,00,000
• The book value per share is INR 1.2.

Graham Number = sqrt

• Graham Number = 14.6969

Ms. A should buy this stock if it trades below INR 14.6969. However, stock trading above INR 14.6969 is considered to be overvalued and should not be carried out.

Advantages of Graham Number

The benefits of the Graham number are as follows.

1. A quick and easy method: A swift and simple way to understand stock valuation is by looking at Graham's number. Use the calculator or a spreadsheet to determine it quickly.

2. Identify bargain stocks: Using Graham's number, investors can identify companies that are likely to be trading at bargain prices.

3. Provides a conservative valuation: Since the formula is based on earnings per share and book value per share, it gives a cautious estimate, reducing the chances of overpaying for a stock.

4. Useful for value investors: It helps investors who follow value investing principles focus on fundamentally strong stocks, avoiding companies that are overpriced or speculative.

Disadvantages of Graham Number

The drawbacks and limitations of the graham number are as follows.

1. Conservative approach The Graham number calculation determines whether or not a company's current market value is essentially at or below its intrinsic value. Therefore, it may be challenging to identify those companies that have a good deal on the basis of this formula. It only works for the positive.

2. EPS and BVPS Many businesses suffer from negative EPS and BVPS figures because they are not profitable. The Graham Number calculation will not cover these firms.

3. Simplification and reliance on one number. For investors not wanting to go through the steps of using all of Graham's recommendations, The Graham Number simplifies most of his investment advice into an individual number. The idea of looking at just one measure before deciding to invest is never a good idea.

How Does the Graham Number Work in Value Investing?

The Graham number works in value investing as a conservative estimate of a stock’s fair value. As mentioned previously, it is calculated using the formula √(22.5 × EPS × BVPS), where EPS is earnings per share and BVPS is book value per share. The constant 22.5 comes from Benjamin Graham’s recommended limits of a P/E ratio of 15 and a P/B ratio of 1.5. If the current market price is below the Graham number, the stock may be undervalued and attractive for value investors. This method helps investors avoid overpaying and focus on fundamentally strong companies with lower downside risk.

Conclusion

Over the past 50 years, it's been widely used by investors to find the best stocks to invest in. But it's less important nowadays, as recent companies are more reliant on technology. This has led to a decrease in the reliance on assets. However, asset-based companies continue to use this method.