Key Takeaways
- Estimates stock's fair value using EPS and BVPS.
- Gives a conservative maximum price for safety.
- Best for stable, low-growth companies.
- Ignores future growth and qualitative factors.
What is Graham Number?
The Graham Number is a value investing metric developed by Benjamin Graham to estimate a stock's fair value. It calculates a conservative maximum price based on a company's earnings and book value, helping investors identify undervalued stocks that trade below this threshold.
By combining earnings per share (EPS) and book value per share (BVPS) using a fixed multiplier, the Graham Number offers a straightforward way to assess intrinsic value without relying on complex forecasts.
Key Characteristics
Key traits of the Graham Number provide clarity and discipline for value investors:
- Formula-based: It uses the square root of 22.5 multiplied by EPS and BVPS, reflecting strict valuation limits.
- Conservative valuation: Designed to ensure a margin of safety by preventing overpayment for stocks.
- Focus on fundamentals: Relies on earnings and book value reported under GAAP accounting principles.
- Limits applicability: Best suited for companies with P/E ratios below 15 and P/B ratios under 1.5.
- Rooted in value investing: Aligns with Benjamin Graham’s emphasis on intrinsic value and risk management.
How It Works
The Graham Number calculates a maximum price by multiplying 22.5 (the product of a P/E limit of 15 and P/B limit of 1.5) with a company's EPS and BVPS, then taking the square root of that result. This formula provides a threshold below which a stock may be considered undervalued.
For example, if a stock’s market price is below the Graham Number, it suggests the stock is trading at a discount relative to its earnings and book value, making it attractive for investors seeking value. However, it excludes growth or speculative stocks that exceed these conservative valuation ratios.
Examples and Use Cases
Use cases for the Graham Number typically center around selecting stable, undervalued stocks with strong fundamentals:
- Airlines: Investors analyzing Delta might apply the Graham Number to gauge whether the stock price fairly reflects its earnings and book value during cyclical downturns.
- Large caps: When screening for undervalued names among large-cap stocks, the Graham Number helps highlight companies trading below conservative valuation limits.
- Dividend-focused portfolios: The metric can complement selections in dividend stocks by ensuring underlying value supports sustainable payouts.
Important Considerations
The Graham Number is a useful tool but has limitations you should consider. It assumes stable earnings and book value, which may not capture growth prospects or changing industry dynamics. You should combine it with qualitative analysis and other metrics.
Additionally, backtesting backtesting its performance on historical data can help validate its effectiveness for your portfolio. Be cautious applying it to sectors where book value understates intangible assets, such as technology or asset-light companies.
Final Words
The Graham Number offers a conservative estimate of a stock’s fair value by combining earnings and book value. To apply it effectively, compare the current stock price to the Graham Number and focus on companies meeting the P/E and P/B criteria.
Frequently Asked Questions
The Graham Number is a value investing metric developed by Benjamin Graham to estimate a stock's fair value. It uses earnings per share and book value per share to provide a conservative maximum price for investors seeking a margin of safety.
The Graham Number is calculated using the formula: the square root of 22.5 multiplied by earnings per share (EPS) and book value per share (BVPS). This formula reflects Graham’s guidelines for a maximum P/E ratio of 15 and P/B ratio of 1.5.
The constant 22.5 comes from multiplying Graham’s suggested maximum price-to-earnings ratio of 15 by the maximum price-to-book ratio of 1.5. This product represents a conservative valuation threshold for stocks.
If a stock’s market price is below its Graham Number, it suggests the stock is undervalued and could be a good buy for value investors. It indicates a potential margin of safety by purchasing below the estimated fair value.
Yes, the Graham Number is best suited for stable, low-growth companies and assumes P/E below 15 and P/B below 1.5. It doesn’t account for future growth, debt, or qualitative factors and may not be applicable to modern growth or speculative stocks.
No, the Graham Number is most effective for stocks trading with a P/E ratio below 15 and a P/B ratio below 1.5. It is not recommended for high-growth, speculative, or companies with ratios exceeding these limits.
The Graham Number supports a conservative value investing approach by identifying stocks priced below their intrinsic value. It helps investors seek a margin of safety, reducing risk by buying undervalued stocks with strong fundamentals.
