Benjamin Graham’s Number is a quick way to find out the maximum price an investor should pay for a stock. Economic conditions keep changing thus I have implemented two calculation methods Fixed and Custom. Both methods use the same formula.
- Fixed: This method implements Benjamin Graham’s number formula. Use this method if you don’t want to make any customization
- Custom: This method allows you to customize the parameters of Graham’s Number. You can create many scenarios to simulate different economic conditions and calculate the intrinsic value of a stock in that economic condition.
What is Graham’s Number Formula?
Graham’s Number is the maximum price so, anything above the calculated value is overpriced for that stock. The formula that derives the Benjamin Graham’s Number is as follows
What do the parameters of Graham’s Number represent?
- 15: This parameter represents the maximum value of the Price-to-Earning (P/E) ratio an investor should pay for a stock.
- 1.5: This parameter represents the maximum multiple of the Price-to-Book (P/B) ratio an investor should pay for a stock.
- EPS: Divide the net earnings by the total number of outstanding shares, you will get Earnings Per Share (EPS).
- BVPS: Subtract total liabilities from the total assets of a company to calculate the company’s Book Value (BV). Divide BV by the total number of shares outstanding to find out the Book Value Per Share (BVPS) of a company.
Why do we need to customize Benjamin Graham’s Number?
Graham’s number is a quick and easy method to calculate the maximum price. Graham uses the same parameter values for every industry. The fixed value approach worked during the time Graham was managing investment portfolios but today circumstances are different.
Now, we have very high-growth companies and a very low-interest-rate environment. Graham’s Number with fixed parameter value approach is not suitable for every industry. You can adjust the value of Graham’s Number’s parameters according to the industry standard and economic conditions.
How to customize the parameters of Benjamin Graham’s Number?
Graham used 15 as the maximum P/E and 1.5 as the maximum P/B. If you don’t know a better assumption to use then use what Graham used. The “Fixed” calculation method in the calculator uses Graham’s suggested value.
If you select the “Custom” calculation method in our calculator, you will have the option to set values of the following 2 parameters
- Maximum P/E
- Maximum P/B
You can customize Benjamin Graham’s Number formula using one of the two following methods
- Industry Mean
- Stock’s long-term Mean
Use Sector/Industry Median
Every industry is different. Industries like high growth tend to trade at a high multiple of P/E and P/B primarily because growth companies burn through a lot of earning and/or take debt to grow.
Maximum P/E = 15 and Maximum P/B = 1.5 are not always justified for all industries. You can take the long-term mean or median of the industry and use that as the Maximum P/E and/or P/B. The industry Mean could be higher or lower than what Graham used in his Number Formula
Use Stock’s long-term (5-10 years) Mean
Everything has a tendency to revert to mean. You can use that method to set the Maximum P/E or P/B value in Graham’s Number Formula. Calculate the stock’s long-term (i.e. 10-15 years) mean of P/E and P/B and use that value instead of P/E=15 and P/B = 1.5. If you use this method you are using a different value for each stock.
Stock’s fair value calculations examples using Graham’s Number
I use Morningstar as the data source of all companies’ fundamentals. Data represent the value as it is at 2021, September.
Valuation using Original Graham’s Number
Let’s apply Original Graham’s Number for the following stocks’ to calculate their fair value. Here, P/E = 15 and P/B = 1.5
|Bank of America
The table shows that you can not calculate the fair value of AT&T because AT&T has negative EPS. This is one limitation of Graham’s Number.
Graham’s Number tends to underestimate high-growth companies that usually trade at a higher P/E multiple. That is because Graham’s Number doesn’t allow you to pay more than P/E=15. You can use our Peter Lynch’s Fair Value Calculator for a quick valuation of a growth stock.
R&D heavy Healthcare companies generally trade a high P/B multiple since those companies need to spend a lot of money upfront to innovate new drugs. Graham’s Number tends to underestimate R&D heavy healthcare companies that usually trade at a higher P/B multiple.
Graham’s Number tends to work best for asset-heavy stable earning companies. Financials, Utility companies are asset-heavy and have a stable income. Bank of America is an example for your understanding.
You can customize the Graham Number by using industry-specific P/E and P/B. Stock’s long-term average P/E and P/B is another way you can customize Graham Number. Let’s use stock’s long-term average P/E and P/B and see how that affects the valuation.
Valuation using Sector Median in Graham’s Number
Let’s apply Sector Median P/E and P/B as the maximum P/E and maximum P/B in Graham’s Number. This customization will let us compare the difference between using one static formula vs industry-specific calculation. I used Seeking Alpha to get the Sector Median P/E and P/B.
|Bank of America
You can clearly see the difference when we use the sector median as the maximum P/E and Maximum P/B.
Graham’s Number for Google and Facebook is still lower than the stock’s current price. This means those stocks are still overvalued.
Alibaba and JnJ are still overvalued but much closer to their current Alibaba and JnJ are still overvalued but much closer to their current stock price.
Bank of America changed from under-valued to over-valued.
Using sector or even industry median as the Maximum P/E and P/B in Graham’s Number gives a more accurate fair value since it takes recent market conditions into the account.
When to Buy/Sell based on Benjamin Graham’s Number?
You should buy and own a stock forever unless the fundamentals of the business change. The ideal time to buy a stock is when it is offering you a big margin of safety. 20-30% below the maximum price calculated by Benjamin Graham’s Number could be a good point of entry.
Try to avoid buying a stock when it is much higher than the calculated value. 20-30% higher than the maximum price calculated by Benjamin Graham’s Number could be a good point of entry.
What are the limitations of Benjamin Graham’s Number?
Benjamin Graham’s Number is a very powerful method to calculate the maximum price of a stock because it is easy for beginners to use. It has some limitations though. Some of the limitations are as follows:
- Use the same value of parameters for every industry. Not all industries are equal, so, parameter customization is necessary
- Does not calculate an exact intrinsic value
- Can not calculate intrinsic value if Earnings Per Share is negative
- Graham’s Number tends to underestimate the high growth stocks
- Do not take the business broader business fundamentals. Only earnings and book value do not always give a complete picture of the underlying business.
You should not base your investment decision only based on Benjamin Graham’s Number method rather, use it as an indication to investigate further.
You should always use more than one valuation method to determine a more accurate value of a stock. To help you with your financial independence journey, I developed a few more Intrinsic value calculators, link below
Who is Benjamin Graham?
Benjamin Graham is often referred to as “the father of value investing“. Graham is famous for his ability to pick undervalued stocks. Warren Buffet is one of his students. Warren Buffet in his early career worked in Benjamin Graham’s Investment firm, Graham-Newman Partnership.
- The Intelligent Investor
- Security Analysis
He is also popular for giving us some very wise quotes on value investing.
In the short run, the market is a voting machine but in the long run, it is a weighing machineBenjamin Graham
If you are shopping for common stocks, choose them the way you would buy groceries, not the way you would buy perfume.Benjamin Graham