Benjamin Graham Number
From Benjamin Graham’s The Intelligent Investor, The Graham Number is used as a simplistic calculation not to be confused with the Benjamin Graham Intrinsic Value Formula, which is used as a simplistic way to calculate fair value. The Graham Number is meant as a simplistic test for the defensive investor.
The Graham number represents the upper bound of a price that a defensive investor should pay for a stock. Any stock that is priced below the calculation of it’s Graham number would be considered undervalued. This is presented as a general test to identify stocks and in general will not apply to large majority of stocks in the market that are of medium to large cap size during normal market conditions. During recessions you will find some. Why 22.5? The 22.5 number included is calculated through the basis that you should purchase companies that have a price to earnings ratio larger then 15 and the price to book ratio should not be over 1.5.
Example Calculation Bank of America: data as of 1/13/2014
Earnings Per Share for Trailing Twelve Months = 0.66, Book Value = 20.50 per Yahoo Finance
sqrt(22.5 * 0.66 * 20.50) = $17.50
Which gives us fair value for Bank of America of $17.50. Some may argument whether we should use book value of $20.50 or tangible book value, and some may argue the earnings and whether or not we should expect more growth in the earnings. However assuming our numbers were true then the current market price as of 1/13/2014 of $16.43 would represent a greater than 6% discount to fair value that we’ve calculated.
The Graham number is a very conservative equation and implies very low growth and in a scenario where earnings per share is expected to raise will be conservative. One could modify the 22.5 portion of the equation for larger growth assumptions but then we would be violating the tenant of Graham to not buy with the assumption of growth. One could also argue that Bank of America isn’t worth a multiple of its book value like a Wells Fargo and modify the 22.5 so that you apply your own assumed Price to Earnings Multiple * Book Value Multiplier. Using the average for peers of the company you are evaluating could be considered “conservative”. Remember when we invest we are looking to apply margins of safety.
That is a quick and dirty example of The Graham Number.