When Should You Use Graham Number in Stock Valuation?

Ben Graham gave us many of the core concepts of value investing. He also gave us a few shortcuts. Graham Number is one of the shortcuts an investor can take to estimate the intrinsic value of a stock.

What is the Graham Number?

Most value investors know to look at the two primary ratios for every stock they evaluate:

• the Price/Earnings ratio, and,
• the Price/Book ratio

Readers of this site will recognize that proper valuation of any stock is much more than just these 2 ratios, but they give us a good start. Graham himself considered these 2 ratios to be a good proxy to estimate the intrinsic value of a stock.

Also, if you recall, the normal advice is to look at stocks that exhibit the following multiples

• Price < 15 x Earnings Per Share, and,
• Price < 1.5 x Book Value Per Share

The Graham Number combines these 2 recommendations into 1 and suggests that a rough approximation of the intrinsic value can be estimated as follows:

Intrinsic Value of a Stock ~ √( 15 x EPX x 1.5 x BVPS), or, √(22.5 x EPS x BVPS)

For example, a stock with  an EPS of $2/share and Book Value of $10/share has an estimated intrinsic value of

√(15 x 2 x 1.5 x 10) = $6.71/share

If the stock price is under $6.71/share, the stock can be considered undervalued. If the stock price is over $6.71/share, the stock can be considered overvalued.

When to Use the Graham Number?

When I run my screens, I generally have stricter criteria for P/E and P/B ratios. There are many other filters added as well. However, in my experience, when I am looking at large capitalization stocks, I relax my criteria a bit and end up looking at 15 times earnings and 1.5 times book value multiples which align very well with the Graham Number concept.

It is important to note that using the Graham Number means we are not paying attention to other determinants of value. For example, the management effectiveness, market power or competitive advantage, earnings growth rate, etc are not considered. Consequently, Graham Number by necessity needs to be used as a shortcut for a quick estimate of value. For example, during an initial screen. Graham Number does not provide an accurate assessment of the intrinsic value.

Given the constraints, perhaps the companies that are most suitable for this type of analysis are the ones that do not have much of “special situations” surrounding its business. A standard company doing standard things with a standard capital structure and paying a standard dividend are the best sort of companies where Graham Number analysis will work. We do not have many such companies. However, large cap stocks are the closest we can get to the level of standardization we seek.

If you invest in mid cap, small cap, distressed debt or special situation stocks, I recommend you do not use the Graham Number analysis for anything much more than as an initial screening criteria.

Please note that Graham’s body of work in value investing included many such shortcuts to valuation. Graham Number is one such method and it should not be confused with a more detailed Graham Checklist that can be used as an investment checklist that considers many many more factors when evaluating a stock. Graham also pioneered the concept of net-net stocks that uses a modified book value, called the net current asset value, to value a stock.