The Graham Number as a value indicator

Posted by BM on April 26, 2021 

We use the Graham Number to aid in our selection process and decide which businesses make good candidates for further research.

The Graham Number is a figure that measures a stock’s fundamental value by considering the company’s earnings per share and book value per share. The Graham Number is the upper bound of the price range that a defensive investor should pay for the stock. According to the theory, any stock price below the Graham Number is considered undervalued and thus worth investing in. The formula is as follows:

The Graham value/price we use is a modified version: square root of ((average of last three years earning per share * book value per share) * 22.5).

Source: Tom Connolly

The term is also sometimes referred to as Benjamin Graham’s Number.

Understanding the Graham Number

The Graham Number is named after the “father of value investing,” Benjamin Graham. It is used as a general test when trying to identify stocks that are currently selling for a good price. The 22.5 is included in the calculation to account for Graham’s belief that the price to earnings ratio should not be over 15 and the price to book ratio should not be over 1.5 (15 x 1.5 = 22.5).

The 7 Filters for Using the Graham Value:

1. Seek Safety with Large Predictable companies.
   1. Look for stocks with at least $100m in sales (back in 1970’s). Adjusted for inflation, that number should be around $465 million. We use $1 Billion for our Canadian dividend growth companies.
2. Strong Financial Condition to Prevent Bankruptcy.
   1. Current ratio > 2
   2. Long term debt < working capital
3. Earnings Stability.
   1. No losses over the past 10 years. Companies that can maintain positive earnings are more stable.
4. Consistent Dividends.
   1. The company should have a history of paying dividends without problems for the past 20 years. Check the payout ratio here. There are very few Canadian dividend growth companies with a record of 20 years (only 7). We use 10 years of dividend growth instead
5. Earnings Growth.
   1. Net income per share should have increased by at least a 1/3 in the past 10 years.
6. Price to Earnings Ratio Below 15.
7. Price to Book below 1.5.

You can see that points number 6 and 7 make up the Graham Number.

Combine criteria 1 through 5 and you have got the full Graham Number methodology.

But there are limitations you must know.

1. Only works for companies with positive earnings and positive tangible book value.
2. Graham Number does not take growth into account. Therefore, it underestimates the values of the companies that have good earnings growth. We feel that if the earnings per share grows more than 10% a year, Graham Number underestimates the value.
3. Graham Number punishes the companies that have temporarily low earnings. Therefore, an average of earnings makes more sense in the calculation of Graham Number.
4. Underestimates stocks with little tangible assets or companies that are book ‘light’. Industries like software, service and information will not make the list.

In general, the Graham Number is a very conservative way of valuing a stock. It cannot be applied to companies with negative book values.

Source: Old School Value website

https://www.oldschoolvalue.com/stock-valuation/graham-number/

We do a sort on ‘The List’ list using the Graham Number to compare with a stock’s current price. If the current price is significantly higher, we do not investigate further. On the other hand, a positive percent difference between the Graham Number (GRAHAM $) and the current price (PRICE $) tells us to look closer.  I generally review stocks with a current price within 20% of the GRAHAM $ to be sure I don’t miss a good BUY signal.

Here is ‘The List’ with comments, sorted in G%D order as of April 23, 2021.  GRAHAM-The List-04-23-2021.PDF