Graham’s PE Formula of Intrinsic Value

One of the methods which I use to value to stock is the Benjamin Graham’s formula from The Intelligent Investor.

The original formula from Benjamin Graham’s book, Security Analysis, is

graham-formula-old
image from Wikipedia.com

where V is the intrinsic value, EPS is the trailing 12 month EPS, 8.5 is the PE ratio of a stock with 0% growth and g being the growth rate for the next 7-10 years.

However, this formula was later revised as Benjamin Graham included a required rate of return.

graham-formula-update
image from Wikipedia.com

Graham determined 4.4 to be his minimum required rate of return. At the time around 1962 when Graham was publicizing his works, the risk free interest rate was 4.4% but to adjust to the present, we divide this number by Y, which is the current yield of today’s AAA corporate bond rate.

My take on the forumla

Adjusted EPS in the formula

An important note that I would like to highlight is that EPS should not be taken at face value. It must always be adjusted to remove that one time huge surge or dip (eg, disposal of property which led to increase in EPS). Companies will never go out of their way to make their earnings lower than it is, even if they follow proper accounting procedures.

Forecasting growth rates

Graham wrote extensively about the unreliability of estimates in finance. Here is a quote from his book The Intelligent Investor.

Because the experts frequently go astray in such forecasts, it is theoretically possible for an investor to benefit greatly by making correct predictions when Wall Street as a whole is making incorrect ones. But that is only theoretical. How many enterprising investors could count on having the acumen or prophetic gift to beat the professional analysts at their favorite game of estimating long-term future earnings?

Benjamin Graham, Chapter 1: Investment versus Speculation, The Intelligent Investor
.

I prefer not to make my investment decisions based on forecast and projections. As such, I would usually give a very low or even zero growth rate when I crunch my numbers.

The “2 x G” is quite aggressive in my opinion. So I’ve have reduced the multiplier to 1 instead of 2.

In his formula, he also uses PE of 8.5 as a fair valuation for a no growth company, in my case, I use 8 for a simple fact that it is easier to multiply the EPS off your head. You can change to whichever multiple you want, depending on your conservativeness. but I feel that anything between 7 and 8.5 should be okay.

Corporate Bond Rate

Moody’s AAA corporate bond rate is currently 3.7%. However, most of the companies that I am studying are in Singapore. That is why I decided to use a more conservative 4%, which is Singapore’s CPF Special Account Interest Rate. The reason being if I can’t achieve returns more than what CPF is giving, I might as well put everything there.

Moss Piglet’s adjusted Ben Graham formula

By making the adjustments, we get:

Testing the adjusted formula

Let’s look at AEM (SGX:AWX) one of the hottest stock in SGX last year.

  • EPS = $0.12
  • g = 0
  • Y = 4

V = 1.056 The intrinsic value comes out at $1.056, which gives about 15% margin of safety with current price of $0.89.

Playing with the numbers, you can see that there will be a big difference if you include a growth rate, say 20% (Google’s 10yr growth rate is 18.5% CAGR). The difference gets larger if you used the original graham’s formula. I’m guessing that in Graham’s time, there was no such thing as 30%, 40% or 50% growth companies like Facebook, Google and Microsoft.

Conclusion

Benjamin Graham has given us a very simple formula to calculate a growth stock. It can be applied to all sectors and industries but you must put it into context by adjusting the original formula. I would consider this formula to be the upper end of the valuation range. For me, I like to use PEx8 when doing off the head calculations to avoid all the hassle.

Always have a margin of safety when investing. It is also important to understand that valuation is finding a range of numbers and the price that you get will vary based on your assumptions. Always try to come up with both best and worst case scenarios and you will have a range of values to work with. The fair value will be somewhere inside this range.

Cheers

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