Is the Graham Formula Still Relevant to Underpriced Stocks Today?

Jeremy Biberdorf  |

Benjamin Graham is widely considered as one of the foremost minds in investment history.Known by a wide array of monikers such as the ‘Father of value investing’ and the ‘Dean of Wall Street,’ there was a chance he knew a thing or two when it came to shrewd business acumen. When it comes to underpriced stocks & the Graham Formula, we can see why he was so revered.

Graham, who acted as the mentor of Warren Buffett, was a proven genius when it came to demonstrating his own philosophy on investing. This investment master’s partnership returned approximately 20% on the initial investment over 20 years from 1936 to 1956, which worked out at $38 on each $1 invested. The methods he used to do this are ingrained in the history books as a result.

You may be forgiven for thinking that those said methods are complicated or intricate calculations of some sort. The truth is, Graham liked to keep things simple. In the ever-changing world of investing, it is interesting to pair the current trading landscape – with all considered technological advancements and evolutions – with the simple Graham Formula. Does it work today?

The Graham Formula and Underpriced Stocks

Graham’s formula effectively encompassed a number of differing principles to determine the stocks which were trading at favorable valuations. By isolating particular stocks to invest in, these methods would have been used prior to committing to invest in any of them. The Graham Formula – much like other valuation methods – was not used to attempt to value a stock. Alternatively, it was used to approximate the value of the stock.

The formula itself was simple in how it was initially devised:

V* = EPS x (8.5 + 2g)

V* = Intrinsic value

EPS = Trailing twelve months earnings/share

8.5 = P/E base for a no-growth company

g = reasonably expected 7 to 10 year growth rate

Graham’s philosophy was to keep things as simple as possible. Shunning intricate calculations, Graham commented on his ‘foreshortened’ and ‘simple’ formula in his book, The Intelligent Investor:

“Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the evaluation of growth stocks. This is intended to produce figures fairly close to those resulting from the more refined mathematical calculations.”

Opportunity Cost Relative to Risk

As direct as this was, the sum did not take into account a number of potential economical adjustments and macro-economic factors. In 1974, Graham altered his method:

V = {EPS x (8.5 + 2g) x 4.4} / Y

Y: the current yield on 20 year AAA corporate bonds.

V* = Intrinsic value

EPS = Trailing twelve months earnings/share

8.5 = P/E base for a no-growth company

g = Expected long term earnings growth rate

4.4 = Average yield of high-grade corporate bonds in 1962, when the formula was introduced

In the modern age, there are still a significant amount of traders who would recommend stocks on the basis of using the V = EPS x (8.5 + 2g) formula. When answering protractors, the likelihood is that they will defend their use of the Graham number by stating that intrinsic value is only an estimate, and therefore, similar warnings are applicable to all valuation methods.

The Graham Number in Modern Times

The use of the Graham Formula in underpriced stocks is still apparent in modern times. Other noteworthy investors, however, will refute its credibility based on its simplicity and adherence to the belief that stock markets are efficient (such as the Efficient Market Hypothesis).

George Soros' Theory of Reflexivity, for example, goes the other way and argues that our ability to perceive reality is and will always be intrinsically flawed. As such, factoring this basic principle into our approach in swearing by the Graham Formula may help us to decide of its place in the second decade of the 21st Century.

Written by Jeremy Biberdorf

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The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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