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Graham Number

Graham Number
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What Is the Graham Number?

The Graham number (or Benjamin Graham's number) measures a stock's fundamental value by considering the company's earnings per share (EPS) and book value per share (BVPS).

The Graham number is the upper bound of the price range that a defensive investor ought to pay for the stock. As per the theory, any stock price below the Graham number is considered undervalued and in this manner worth investing in.

The Formula for Graham Number

22.5 × (earnings per share) × (book value per share)\sqrt{22.5\ \times\ \text{(earnings per share)}\ \times\ \text{(book value per share)}}

Where:

  • Earnings per share (EPS) is calculated as a company's net profit divided by the number of outstanding shares of its common stock.
  • Book value per share (BVPS) is the ratio of equity available to common shareholders divided by the number of outstanding shares. This figure represents the base value of a company's equity and measures the book value of a firm on a per-share basis.

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 attempting to identify stocks that are currently selling at a decent cost. The 22.5 figure is included in the calculation to account for Graham's belief that the price-to-earnings (P/E) ratio ought not be over 15x and the BVPS ought not be over 1.5x (accordingly, 15 x 1.5 = 22.5).

The Graham number can subsequently be alternatively calculated as:
15 × 1.5 × (net incomeshares outstanding) × (shareholders’ equityshares outstanding)\sqrt{15\ \times\ 1.5\ \times\ \left(\frac{\text}{\text}\right)\ \times\ \left(\frac{\text{shareholders' equity}}{\text}\right)}

Essentially, this second method of calculation is equivalent to the first, wherein EPS = net income/shares outstanding, and book value is another term for shareholders' equity.

As indicated by Benjamin Graham, the current price ought not be more than 1 1/2 times the book value last reported. However, a multiplier of earnings below 15 could legitimize a correspondingly higher multiplier of assets. As a rule of thumb, the product of the multiplier times the ratio of price to book value shouldn't exceed 22.5.

Example of the Graham Number

For example, if the earning per share for a single share of company ABC is $1.50, the book value per share is $10, the Graham number would be 18.37. ((22.51.510)1/2= 18.37). Once more, $18.37 is the maximum price an investor ought to pay for a share of ABC, as per Graham. In the event that ABC is priced at $16, it is attractive; whenever priced at $19, it ought to be avoided.

Limitations of the Graham Number

The calculation for the Graham number does leave out numerous fundamental characteristics, which are considered to comprise a wise investment, for example, management quality, major shareholders, industry characteristics, and the competitive landscape.

With regard to stocks and equity instruments, fundamental analysis is a method of determining the value that focuses on key metrics and economic indicators, like revenues, earnings, where an industry is in its cycle, return on equity (ROE), and profit edges.

Fundamental analysis relies on a company's financial statements. One of the most popular and successful fundamental analysts, Warren Buffett — also known as "the Oracle of Omaha" — is renowned for successfully employing fundamental analysis. Warren Buffett was both a student and employee of Benjamin Graham. The fundamental method of security analysis is considered to be the opposite of technical analysis.

Features

  • The Graham number is a metric to determine the highest price that an investor ought to pay for a particular stock.
  • The Graham number is normalized by a factor of 22.5, to represent an 'ideal' P/E ratio of something like 15x and a P/B of 1.5x.
  • The number is arrived at utilizing a company's earnings and book value, both on a per-share basis.
  • It was developed by legendary value investor Benjamin Graham.

FAQ

Who Was Benjamin Graham?

Benjamin Graham is one of the initial architects of value investing, and a financial master to numerous popular value investors like Warren Buffett. Graham's philosophy was to closely examine a company's financial statements to identify undervalued opportunities. His book, The Interpretation of Financial Statements is widely regarded as essential for value investing.

What Is a Good Graham's Number?

Graham's number will constantly present a maximum stock price given a company's EPS and BVPS. As a result, any stock price below that figure ought to signal a decent buy for a value investor.

How Does the Graham Number Work in Value Investing?

The Graham number takes a company's per-share metrics and normalizes it based on a recommended upward limit for value investors of 15x P/E and 1.5x P/B.