Benjamin Graham's Equation: Finding the Most Undervalued High Yield Dividend Stocks

Value-driven investors all ultimately want the same thing -- a portfolio of stocks trading at a discount to their fair market value. However, there's no clear consensus as to how reach this end goal. Some investors seek out stocks with low price-to-earnings ratios; others screen for low price-to-cash-flow ratios, or low price-to-book ratios.

But taken alone, these metrics don't necessarily always paint the most accurate picture. Which is why many investors are keen to use a stock's Graham Number as an alternative way to determine value. 

Benjamin Graham, aka the "Godfather of Value Investing," advocated a defensive approach to investing. According to Graham, a strategy based around locating undervalued stocks was the safest, surest way to thrive in a tumultuous market. He championed the concept of margin of safety, the difference between a stock's intrinsic value and market price, making it the lynchpin of his philosophy. 

Graham's principles of value investing serve as the basis 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)

For Graham, price-to-earnings (P/EPS) ratio should be no more than 15 and price-to-book value (P/BVPS) ratio should never exceed 1.5.

As a general rule, Graham insisted that the product of the two shouldn't 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

Take the square root of both sides, and you get the equation for the Graham Number.

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

It's a useful way to help determine a stock's relative value -- but it's no substitute for your own research. Use it as a starting point for further analysis. (Click here to access free, interactive tools to analyze these ideas.)

For our list of ideas, we started with a universe of high yield dividend stocks, stocks seeing relatively high dividends per share when compared with price per share. We then crunched the financials on those stocks and identified a few dividend stocks that are trading below their Graham numbers. In other words, these high-yield stocks appear to be undervalued -- what do you think?

(Take a look at prior companies that've passed the Ben Graham screen.)

Company

Industry

Dividend Yield

Graham Number Calculation

Upside Potential From Current Levels

Universal Corp. (NYSE: UVV  )

Tobacco Products

4.60%

TTM diluted EPS at 5.35, MRQ BVPS at 40.89, i.e. Graham Number = sqrt(22.5*5.35*40.89) = $70.16

Current price at $41.71 vs. Graham number at $70.16 (implies upside of 68.2% from current levels)

Ennis (NYSE: EBF  )

Office Supplies

4.02%

TTM diluted EPS at 1.72, MRQ BVPS at 13.07, i.e. Graham Number = sqrt(22.5*1.72*13.07) = $22.49

Current price at $15.43 vs. Graham number at $22.49 (implies upside of 45.76% from current levels)

Federal Signal Corp. (NYSE: FSS  )

Trucks & Other Vehicles

4.33%

TTM diluted EPS at 0.39, MRQ BVPS at 6.48, i.e. Graham Number = sqrt(22.5*0.39*6.48) = $7.54

Current price at $5.54 vs. Graham number at $7.54 (implies upside of 36.11% from current levels)

Star Gas Partners (NYSE: SGU  )

Specialty Retail

5.70%

TTM diluted EPS at 0.52, MRQ BVPS at 4.41, i.e. Graham Number = sqrt(22.5*0.52*4.41) = $7.18

Current price at $5.44 vs. Graham number at $7.18 (implies upside of 32.04% from current levels)

SK Telecom Co. Ltd. (NYSE: SKM  )

Wireless Communications

5.25%

TTM diluted EPS at 1.68, MRQ BVPS at 15.2, i.e. Graham Number = sqrt(22.5*1.68*15.2) = $23.97

Current price at $18.39 vs. Graham number at $23.97 (implies upside of 30.34% from current levels)

Formula Systems (1985) Ltd. (Nasdaq: FORTY  )

Business Software & Services

8.55%

TTM diluted EPS at 1.57, MRQ BVPS at 13.68, i.e. Graham Number = sqrt(22.5*1.57*13.68) = $21.98

Current price at $17.2 vs. Graham number at $21.98 (implies upside of 27.81% from current levels)

BVPS and EPS data sourced from Yahoo! Finance. The list has been sorted by the implied upside to the Graham Number.

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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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 April 02, 2011, at 10:49 PM, dragonshon wrote:

    I extremely like this article. Very informative and thorough, yet simple and to-the-point. Most investors (with formal investment education or not) do not realize this formula...

    Shon

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