Benjamin Graham, often regarded as the father of ‘value investing’ and a mentor to Warren Buffet, introduced the concept of the Graham Number. This numerical formula is a fundamental tool to identify undervalued stocks, assisting investors in making informed decisions in the stock market.

What Exactly is the Graham Number?

The Graham number is a fair valuation metric representing the maximum amount a defensive investor, typically one with a passive approach to investments, is willing to pay to purchase a stock. If a stock is trading below its Graham number, it is considered undervalued.

The formula to calculate the Graham number involves two crucial financial indicators: Earnings Per Share (EPS) and Book Value Per Share (BVPS). This approach was derived from Benjamin Graham’s principle of ‘moderate price to assets ratio,’ where a stock’s current price should not exceed the book value multiplied by 1.5.

The Graham Number Formula:

The Graham number = sqrt(22.5 * EPS * BVPS)

Where:

  • Earnings Per Share (EPS) = Net income ÷ No. of outstanding shares
  • Book Value Per Share (BVPS) = Shareholder’s equity ÷ No. of shares outstanding
  • 22.5 is based on Graham’s assumption that an undervalued stock’s price-to-earnings ratio (PE ratio) should not exceed 15, and the price-to-book ratio (PB ratio) should not exceed 1.5.

However, it’s important to note that this formula is not suitable for companies running in losses or those in asset-light industries. Furthermore, the price-to-earning ratio and the price-to-book ratio should not exceed 15 and 1.5, respectively, for the formula to be applicable.

Applying the Graham Number: An Example

Let’s consider an example to understand how the Graham number is used. If a company’s earnings are INR 40,00,000, shareholders’ equity is INR 600,000, and outstanding shares are 500,000, the Graham number would be calculated as follows:

  • Earnings Per Share (EPS) = 40,00,000 ÷ 5,00,000 = INR 8
  • Book Value Per Share (BVPS) = 6,00,000 ÷ 5,00,000 = INR 1.2
  • Graham Number = sqrt(22.5 * 8 * 1.2) ≈ INR 14.6969

In this scenario, if the stock is trading below INR 14.6969, it is considered undervalued and a potential buy. On the other hand, a stock trading above this value is seen as overvalued and should be approached with caution.

In conclusion, the Graham number remains a valuable tool for investors seeking undervalued stocks in asset-based businesses. However, it should always be used in conjunction with a comprehensive analysis of other factors like management quality, sector analysis, and overall financial health of the target company.