The Godfather of Value Investing's Secret Formula: 6 Stocks Trading Below Their Graham Numbers

Value investing, in a nutshell, simply means getting the most bang for your buck, by purchasing a stock for less than what you believe it's worth. Followers of this philosophy may agree on the logic, but there are many divergent schools of thought when it comes to actually determining value.

Some look for stocks selling at low price-to-book ratios with high dividend yields. Others seek out companies with low P/E ratios. But these metrics don't always tell the whole story -- just ask Warren Buffett: "Such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth."

Buffett's own strategy is predicated on a few basic tenets developed by his mentor, Benjamin Graham, the so-called godfather of value investing.

Graham's axioms serve as the inspiration for the Graham Number, or the maximum price an investor should pay for a stock. It's derived using only two data points: current earnings per share and current book value per share.

The Graham Number:

Fair Value of a Stock = Square Root of (22.5) x (Earnings Per Share) x (Book Value Per Share)

The math of the Graham number is relatively straightforward. Graham believed that the price-to-earnings (P/EPS) ratio should be no more than 15. He also believed that the price-to-book value (P/BVPS) ratio should be no more than 1.5.

From that, Graham proposed that -- as a rule of thumb -- the product of the two should not be more than 22.5. In other words, (P/EPS of 15) x (P/BVPS of 1.5) = 22.5.

Put another way:

(Price/EPS) x (Price/BVPS) = 22.5

Price(sqr)/(EPS x BVPS) = 22.5

Price(sqr) = 22.5 x EPS x BVPS

Once you take the square root of both sides, you get the equation for the Graham Number.

Fair Value Price = Square Root of (22.5 x EPS x BVPS)

The Graham Number can be helpful in determining the relative value of the stock you're looking at. Bear in mind, it's not a substitute for doing own your homework -- but it can be a good starting point for your research.

To help you find a few ideas, we started with a universe of rallying stocks. We then crunched the financials on those stocks, and identified a few stocks that are trading below their Graham numbers. In other words, these rallying stocks appear to be undervalued -- what do you think? (Click here to access free, interactive tools to analyze these ideas.)

Company

Calculation of Graham Number

Potential Upside to Graham Number From Current Levels

Capital One Financial (NYSE: COF  )

Trailing 12 month diluted EPS of 6.01, Book Value per Share at 58.62. Graham number = sqrt(22.5 x 6.01 x 58.62 = $89.03

Current price at $52.43 vs. Graham number at $89.03, implies upside potential of 69.81%

Unitrin (NYSE: UTR  )

Trailing 12 month diluted EPS of 3.02, Book Value per Share at 35.81. Graham number = sqrt(22.5 x 3.02 x 35.81 = $49.33

Current price at $29.16 vs. Graham number at $49.33, implies upside potential of 69.16%

Fushi Copperweld (Nasdaq: FSIN  )

Trailing 12 month diluted EPS of 1.26, Book Value per Share at 9.14. Graham number = sqrt(22.5 x 1.26 x 9.14 = $16.1

Current price at $9.74 vs. Graham number at $16.1, implies upside potential of 65.27%

Tenet Health care (NYSE: THC  )

Trailing 12 month diluted EPS of 1.95, Book Value per Share at 2.84. Graham number = sqrt(22.5 x 1.95 x 2.84 = $11.16

Current price at $6.95 vs. Graham number at $11.16, implies upside potential of 60.61%

Micron Technology (NYSE: MU  )

Trailing 12 month diluted EPS of 1.77, Book Value per Share at 8.25. Graham number = sqrt(22.5 x 1.77 x 8.25 = $18.13

Current price at $11.62 vs. Graham number at $18.13, implies upside potential of 55.99%

Boise (NYSE: BZ  )

Trailing 12 month diluted EPS of 1.09, Book Value per Share at 8.19. Graham number = sqrt(22.5 x 1.09 x 8.19 = $14.17

Current price at $9.2 vs. Graham number at $14.17, implies upside potential of 54.05%

BVPS and EPS values sourced from Yahoo! Finance.

Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research. Note: The numbers on top of items represent the forward P/E ratio, if available.


Kapitall's Eben Esterhuizen and Alicia Sellitti do not own shares of any companies mentioned.

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Read/Post Comments (4) | Recommend This Article (11)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 16, 2011, at 2:44 PM, cyork2 wrote:

    Half an hour ago I noted that the Motley Fool has published articles just days apart contradicting whether to invest in Tenet Healthcare or not. Now, with this article, the contradictions come just hours apart. One article published earlier today on "Value Traps" warned against Tenet Healthcare and now this article promotes Tenet healthcare.

    Get it together Fool.

  • Report this Comment On February 16, 2011, at 4:40 PM, blesto wrote:

    cyork2,

    The term "Motley" in The Motley Fool is all about encouraging different points of view on the same equity. All part of due diligence that you see both sides of the coin and then you make your own decision on any said equity. And only time will tell who is right.

    Towing the company line at the Fool is not neccessarily agreeing with the other Fools.

    Difference of opinions are encouraged at the Fool to the best of my knowledge.

    And this particular article is by Kapitall

    http://www.backstage.kapitall.com/about-us/

    Which I can only guess is a website/service being promoted by the Motley Fool.

    So be Motley and Fool on!

  • Report this Comment On February 17, 2011, at 12:11 PM, feudi wrote:

    Graham numbers sound like just so much more gibberish dreamt up by the same actuaries who dreamt up CDO's, credit default swaps, hedge funds, securitizations, and "off balance sheet" transactions. Money is not something you can "engineer". Profit is made by providing goods and services that the customer wants. Graham numbers and about as accurate in picking stocks as counting the number of crumbs from graham crackers that spill on your Wall Street Journal.

  • Report this Comment On July 17, 2012, at 4:44 PM, TheAccidentOf85 wrote:

    Its 18 months later....most if not all of these companies have dropped, significantly, and never marched towards their Graham number

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