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What Is the Graham Number?

Sebencapital

Published
17/01/24
What Is the Graham Number?

DEFINITION:

The Graham Number is a tool that helps investors figure out if they're spending too much when buying a stock. This calculation is based on the ideas of Benjamin Graham, a renowned investor and mentor to Warren Buffett. In his well-known book "The Intelligent Investor," Graham outlined principles that later became the basis for the Graham Number.

Definition and Example of the Graham Number

The Graham Number is a simple tool for investors like you to figure out the maximum amount you should pay for a stock. It follows the investing principles set by Graham.

Note

Benjamin Graham wrote a book called "The Intelligent Investor," first published in 1949. Warren Buffett, who considers reading this book one of the luckiest moments in his life, described it as highly influential.

The Graham Number formula suggests that a stock's price should be equal to or less than the square root of 22.5 times the earnings per share (EPS) multiplied by the book value per share (BVPS). In simple terms, it helps investors determine if a stock is priced reasonably based on its earnings and book value.

Price ≤ √(22.5 x EPS x BVPS)

If you want to check if a company's share price is reasonably valued, you can use the Graham Number formula. Look up the company's earnings per share (EPS) and book value per share (BVPS), then put them into the formula mentioned earlier.

The result you get is the maximum you should pay for a stock. If the actual share price is higher than this number, the stock might be too expensive. It's a signal to think carefully before deciding whether or not to invest.

It's important to note that the Graham Number formula isn't directly provided in "The Intelligent Investor." Instead, the book outlines various crucial factors to consider before investing, like the relationship between earnings per share and book value. The Graham Number is a tool developed based on these guidelines.

How Does the Graham Number Work?

The Graham Number is one of seven criteria recommended by Graham in "The Intelligent Investor" for defensive investors looking for good investment opportunities. Among these criteria, Graham advises finding companies with a reasonable ratio of price to assets.

In his book, Graham explains this strategy more, and he indirectly provides the formula when discussing some important points:

  • The share price at the moment should be no more than 15 times the average earnings of the past three years.
  • The current share price should be no more than 1.5 times the book value per share from the last quarter.
  • Graham believed that if the earnings multiplier is less than 15, a higher multiplier for assets could be acceptable. So, he suggested that the result of multiplying the multiplier by the ratio of price to book value should not go beyond 22.5.

All these ideas were put together to create what we now call the Graham Number. It's a handy tool for defensive investors to quickly figure out a fair price for a stock.

For instance, if you want to check if ABC Company's share price is reasonable, you can use the Graham Number. Let's say ABC Company is trading at $55 per share, with an earnings per share (EPS) of $4 and a book value per share (BVPS) of $20. To find the Graham Number, you multiply 22.5 by $4 and then by $20, and finally, you take the square root of that result.

√(22.5 x 4 x 20) = √1,800 = 42.43

In this situation, ABC Company's Graham Number is less than its current share price of $55. Since the Graham Number is the highest amount you should pay for a stock, it suggests that buying shares in ABC Company at $55 per share may not be a good idea.

Note

Another tool called the Graham Formula exists, and it's distinct from the formula for calculating the Graham Number. The Graham Formula is a method to estimate the true value of a stock, which might not be identical to the amount you should actually pay for it.

Pros and Cons of the Graham Number

Pros

  • Simple and fast technique.
  • Find inexpensive stocks.

Cons

  • Safe and careful strategy.
  • Applies only to stocks with positive earnings and book values.
  • Making things too simple and relying too much on a single number.

Pros Explained

  • Simple and Fast: Calculating the Graham Number is a quick and easy way to gauge the value of a stock. You can easily figure it out using a calculator or spreadsheet.
  • Find Cheap Stocks: By using the Graham Number, you can pinpoint companies that are probably trading at affordable prices.

Cons Explained

  • Safe Strategy: The Graham Number helps check if a company's current stock price is, in theory, at or below its true value. However, it might be challenging to identify companies with good value using this formula alone.
  • Limited to Profitable Companies: This method only suits companies that are making a profit. If a company is not yet profitable, meaning it has negative earnings and book values, the Graham Number won't be applicable.
  • Simplifying Too Much: The Graham Number condenses a lot of Graham's investing guidance into a single number for those who prefer an easy approach. However, relying solely on one metric is not a wise strategy when making investment decisions.

What It Means for Individual Investors

Investors seeking stocks priced at or below their fair value can use the Graham Number calculation to identify potential opportunities. It's a quick and easy calculation that takes just seconds and gives an idea of a company's current share price value.

While the Graham Number is a useful tool, it's essential to remember it's just one of many methods for analyzing stocks. Don't rely solely on it; consider using various tools to build a successful investment portfolio.

Key Takeaways

  • The Graham Number is a fast way for investors to figure out the highest price they should pay for a share of stock.
  • To find the Graham Number, we use two things: earnings per share (EPS) and book value per share (BVPS).
  • The Graham Number formula is simple: the price should be equal to or less than the square root of 22.5 multiplied by the earnings per share (EPS) and the book value per share (BVPS).
  • You can only use the Graham Number formula for companies that have positive earnings per share and book value per share.
  • Don't rely only on the Graham Number when making investment decisions.

Written by Sauravsingh

Techpreneur and adept trader, Sauravsingh Tomar seamlessly blends the worlds of technology and finance. With rich experience in Forex and Stock markets, he's not only a trading maven but also a pioneer in innovative digital solutions. Beyond charts and code, Sauravsingh is a passionate mentor, guiding many towards financial and technological success. In his downtime, he's often found exploring new places or immersed in a compelling read.

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