Picture yourself as an investor trying to assess the fundamental value of a particular stock to decide whether it’s undervalued and worth buying. Analysts and investors throw around different valuation techniques and metrics, but what if there was a simpler approach? That's where the concept of the Graham Number comes in handy. Here's what it is, why it's significant, and how you can apply it.
The Graham Number is an uncomplicated and conservative method of calculating the fundamental value of a company's stock. Named after its developer, Benjamin Graham - who is widely recognized as the "father of value investing" - this number helps investors identify potentially undervalued stocks.
The calculation is based on a company's earnings per share (EPS) and book value per share (BVPS) and reflects Graham’s desire not to overpay for a stock.
The Graham Number can simplify the decision-making process for investors, making it an important cog in the wheel of investing strategies. It allows investors to quickly zero in on potentially undervalued stocks without getting lost in complex financial analysis.
Importantly, it aligns with Graham’s fundamental investment philosophy of cautious investing, focusing on safety and avoiding overpayment.
The Graham Number is calculated using the following formula:
Graham Number = √ (22.5 * Earnings per share * Book value per share)
The constant, 22.5, is the product of Graham's suggested price to earnings ratio (P/E) of 15 and the price to book ratio (P/B) of 1.5. If the calculated Graham number is higher than the current stock’s price, the stock is considered undervalued, signaling a buying opportunity for value Investors.
Let's consider a hypothetical scenario. You're interested in investing in a technology stock, TechTeach Inc., which has EPS of $5 and BVPS of $20.
Using the formula:
Graham Number = √ (22.5 * 5 * 20) = $50.91
If TechTeach Inc.'s current stock price is less than $50.91, it could be undervalued according to the Graham Number, and potentially a good buy for a prudent value investor like yourself.
The Graham Number, while a basic tool, offers a rudimentary yet effective way of assessing a stock's fundamental value. For value investors looking to identify undervalued stocks ready for potential investment, it offers a quick and easy benchmark. After all, as often championed by Benjamin Graham, “the best way to measure your investing success is not by whether you’re beating the market, but by whether you’ve put in place a financial plan and a behavioral discipline that is likely to get you where you want to go.”