The Graham Number and Intelligent Investing

What can investors learn from someone who last wrote on investing nearly 40 years ago? The market has changed dramatically since Benjamin Graham opined about the market in Intelligent Investor. With that in mind, I decided to take a look at what individual investors can still learn from Graham today.

Part One of this series introduced Graham and explained how he dealt with inflation and long-term investing. Part Two talked about Graham's distinction between defensive investors and enterprising investors. This article, Part Three, will cover how investors should view a fluctuating market, as well as the well-known Graham Number for evaluating stocks.

Market fluctuations
When Graham last wrote of the stock market, the Dow Jones Industrial Average (INDEX: ^DJIA  ) had yet to pass 1,000 points, topping out around 995 between 1966 and 1968, only to fall back to 630 by 1970. With this in mind, Graham notes that an intelligent investor should be ready to take advantage of the price swings of the market, ultimately profiting from them. An investor can do this in two ways: timing and pricing. By timing, Graham meant speculating on the swings of the market and basing investment decisions on these predictions. By pricing, he meant setting a "fair value" on investments and "buying low and selling high."

As investors, we should not be concerned with short-term fluctuations in stock prices. Ideally, if you pick a stock for the right reasons, you should want to hold onto it forever, selling only when your investment thesis changes about a particular stock. By using only what money you don't need within the next five years for your investments, you can allow your stocks to grow without worrying about the usual fluctuations caused by speculators in the market.

Security analysis for lay investors
Once you have determined that you are ready to ride the wave that sometimes characterizes the day-to-day performance of the market, you need to determine which stocks to buy. There are many ways to evaluate stocks, and each investor probably has different factors that they consider when researching which to buy. Some will take a quick look at P/E relative to peers in an industry and choose the lowest one. Others may invest only in dividend stocks and place all their emphasis on yield. If whatever method that you choose works, I am not going to insist you immediately convert to Benjamin Graham's way of thinking. I am simply providing another method you can use to evaluate investment purchases.

One method that Graham used in evaluating stocks was a calculation that has come to be known as the Graham number. The number is one way to determine the fair value of a stock. The formula is pretty straightforward: Multiply earnings per share by book value per share, then multiply that by 22.5, and finally take the square root. The result, in dollars, is the Graham number.

This is a simple formula that can be programmed into an Excel spreadsheet or other calculation tool to add to you evaluators tool box along with whatever other factors you examine when choosing to invest in a stock.

The chart below indicates the Graham Number of the largest holdings in the Berkshire Hathaway (NYSE: BRK-B  ) stock portfolio, provided as an example because Warren Buffett is perhaps the most famous student of Graham, not necessarily because it is the way that he actually chooses stocks.

Stock

Earnings per share (TTM)

Book value per share (MRQ)

Graham Number

Coca-Cola (NYSE: KO  ) $3.69 $13.98 $34.07
IBM (NYSE: IBM  ) $13.06 $17.36 $71.42
Wells Fargo (NYSE: WFC  ) $2.82 $24.65 $39.55
American Express (NYSE: AXP  ) $4.12 $16.32 $38.90

Source: Yahoo! Finance; TTM: trailing 12 months; MRQ: most recent quarter.

Graham Number wrap-up
Based on recent prices, only one of the stocks on the list is selling for less than its current fair value: banking behemoth Wells Fargo, which closed last week at $30.18. This does not mean that you should rush out and purchase shares so you can laugh all the way to the bank as the stock rushes to match its Graham number. The company is still in one of the most volatile industries in the market, and continued stagnation in the housing and job markets could ultimately affect its future performance.

Similarly, the rich valuations of the other three companies do not mean they are bad investments. The defensive nature of Coke's consumer-driven business makes it a company you can count on. American Express was slammed during the financial crisis of 2008, but is trading at a new 52-week high, and is only about 17% off of its high from May 2007. And IBM, a company mentioned numerous times throughout Graham's book, may simply be the victim of high price bias, with the Graham number not working as well on stocks with extremely high share prices. Again, the Graham number is but one valuation method that can be used to determine the value of a company, not something to be used as the final word in evaluating a company.

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Fool contributor Robert Eberhard owns shares of Berkshire Hathaway. Follow him on Twitter, or click here to see his holdings and a short bio. The Motley Fool owns shares of IBM, Coca-Cola, Berkshire Hathaway, and Wells Fargo, and has created a covered strangle position on Wells Fargo.

Motley Fool newsletter services have recommended buying shares of Coca-Cola and Berkshire Hathaway, as well as writing a covered strangle position in American Express. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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