Who does Warren Buffett consider to be the author of the "the best book about investing ever written?" Benjamin Graham, an investor from the early 20th century whose "value investing" approach has long been held in high regard by the titans of the industry. While some more modern forms of analysis have rejected Graham's teachings, the success of his strongest adherents, like Buffett, continue to show that Graham's concepts on simple value investing still hold some water.
One of the core numbers that Graham used in his valuations of companies was book value. At the core of value investing is the idea of finding fundamentally strong companies at a fair price. The fluctuations of the market will come and go, in Graham's eyes, but the underlying merit of a strong company will remain consistent through these. Therefore, the best approach to investing is to identify those companies with a strong core value and a current market price that is below what it should be.
In identifying these strong companies, Graham often relied on book value, a measure of a company's total value on its balance sheet. Book value is calculated by taking the total assets of a company and then subtracting its intangible assets (like patents or goodwill) and liabilities. More often expressed as price to book or book value per share, this is one of the more traditional methods for valuing a company. A low price to book reveals a company with a low cost to invest but a strong underlying value.
The Graham Number
Benjamin Graham long believed that the best stocks to invest in were those with with a price to earnings ratio under 15 and a price to book ratio of under 1.5. The Graham Number, named after Benjamin Graham, is calculated by taking the square root of 22.5 * earnings per share * book value per share. The 22.5 is a coefficient reached by multiplying 15 and 1.5, the levels that Graham wanted to see for P/E and P/B. At its core, the Graham number should highlight a simple valuation of a company that takes into account both its price and its underlying value. Any stock trading at a price below its Graham number should be viewed as available at a good price, while any stock trading above its Graham number would appear to be overpriced.
For an example, lets look at JP Morgan Chase (JPM) . JP Morgan, as of market close Thursday, had a share price of $37.86. However, should one calculate the Graham number for JP Morgan based on its EPS of $4.47 and book value per share of $48.86, the Graham number comes to 70.1, making JP Morgan well under its project price. For another example, Amazon (AMZN) currently has an EPS of $1.37 and a book value per share of $17.03, giving it a Graham number of 22.91. Compare that to its current share price of $184.98 and Amazon would appear to be overpriced at the moment.
So does this mean one should simply buy on JP Morgan and sell on Amazon? Unfortunately, it's not that easy. Like any investment tool, the Graham number (and value investing as a whole, for that matter) is not a silver bullet. Growing companies like Amazon may appear overpriced but still be a solid investment in the long run. Value investors also have to worry about "value traps," companies that appear to be available at a discount but actually have deeper underlying issues that caused the low price in the first place. Think discount sushi. It's great that it's cheap, but if it's bad fish you're going to regret the decision regardless of the price.
Finally, as with any widely known concept on investing, the market itself is affected by Graham's methods of valuation. The very fact that any investor worth his salt is aware of Graham's teaching means that the market will change the way that companies are valued to reflect that. As such, simply picking stocks based on Graham's valuations is an imperfect tool at best and dangerously shortsighted at worst. Then again, that much is true for any investment strategy, so it isn't necessarily a direct knock on the Graham number.
According to the website of the American Association of Individual Investors, a portfolio using a stock screener pulled from Graham's writings on the Enterprising Investor (to be differentiated from more defensive investors who are more passive in their decision making), a portfolio using Graham's methods would have had an annualized rate of return of 19.6 percent from 1998-1010, with 2009 and 2010 both representing very strong years that would show returns in excess of 43 percent.
However, Graham's teaching are often overlooked in this day in age. Many feel as though Graham's dependence on book value is outdated, while others are stronger adherents now to modern portfolio theory, which eschews individual stock-picking in favor of a broader, more mathematically based approach to diversification. This much would have to be expected as Graham's teachings, now over 70 years old in many cases. However, that Graham's teachings have remained relevant as long as they have and may continue to power successful portfolios into the future speaks to the inherent value of his ideas.