Rule Maker Portfolio Ben Graham's Equation

Benjamin Graham, considered by most to be the father of value investing, offered a valuation equation designed to help estimate what a growth company is worth. The formula is by no means a magic bullet, but it does give us a good place to start when looking at the valuations for Rule Makers.

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By David Forrest (TMF Bogey)
October 31, 2001

Tomorrow is All Saints Day, and what better way to spend this column than talking a bit about the patron saint of value investing, Benjamin Graham? Okay, Mr. Graham isn't really a patron saint, but many consider him the father of value investing, and he's someone we can look to for guidance on how to value a business.

For those who follow Berkshire Hathaway (NYSE: BRK.A) and legendary investor Warren Buffett, you know that Buffett was a student of Graham. You also know that Graham penned two very famous investment tomes, Security Analysis (with David Dodd) and The Intelligent Investor. Of the two, The Intelligent Investor is a little easier to digest, but both are must-haves for any investing library.

In The Intelligent Investor, Graham laid out an equation that was designed to help people value a growth company. The equation goes like this:

P = ProjEPS * (8.5 + (2*G)) * (4.4/AAA yield)

Looks scary, but it's not. Let me break it down for you.

P = the price of the company's stock. This is what the equation will tell you.

ProjEPS = the projected earnings per share. You're looking for next year's estimated earnings per share. (Get estimates here.)

8.5
Graham surmised that a zero growth stock should have a P/E multiple of 8.5. This reflects an average return of 12% per year. For what it's worth, I think this is a little shaky given the wide variety of circumstances leading to a company with zero growth. As you'll see, Graham put some qualifiers on this equation.

2*G
G is the long-term projected growth rate of a company's EPS. Graham said that you should be comfortable that the company will grow its earnings at this rate over the next seven to 10 years. Unfortunately, most companies/analysts only give 5-year expected growth rates, so you'll have to use those.

4.4
This was Graham's benchmark for a required rate of return to invest, period. He surmised that at a minimum, an investor needed to be compensated for the effects of inflation and a small risk premium above that. You might be tempted to "play around" with the 4.4, but I keep it constant.

AAA yield
This is the yield on the AAA corporate bonds. I like to use the 30-year composite yields, but they are difficult to find. Here is a link that's a few weeks dated, but it'll serve for now: http://www.bondresources.com/Corporate/Rates/AAA

The 30-year yield on AAA corporates is about 6.25%.

Okay, so what does all this mean and why am I bothering you with it? Last week, I wrote about risk and expected returns. If you remember, we talked about how investing in one asset class (stocks vs. bonds vs. CDs, etc.) requires that you receive a greater rate of return relative to less risky classes. Graham's equation builds in an equity growth premium as well as an interest rate factor. It's not a magic formula that will solve all of your problems, but it does provide a decent data point to consider in our evaluation of a company's stock price. Let's quickly do an example using Pfizer:

P = 1.59 * (8.5 + (2 * 19.5)) * (4.4/6.25)

P = 1.59 * (8.5 + (39)) * (.704)

P = 1.59 * 47.5 * .704

P = \$53.16

According to this simple equation, Pfizer's value is about \$53. The stock currently trades around \$42.50. If you were to take this as gospel (and you better not), you might conclude that the stock is about 25% undervalued at current prices.

Why am I so cautious and advising you against using this as your "magic dust"? Well, it's only one model, it's imperfect, and it doesn't account for a host of other issues a company may deal with. It also doesn't address other kinds of valuations, such as discounted cash flow analysis, among others.

Graham provided four major caveats to his equation that I should share here. In the book Small Stocks, Big Profits, Dr. Gerald Perritt describes these caveats as follows. In screening stocks, you should:

1. Eliminate all firms with negative earnings (losses).

2. Eliminate all firms with debt to total asset ratios greater than 0.60 (i.e., firms with total debt greater than 60% of total assets).

3. Eliminate all firms with share prices above net working capital per share.

4. Eliminate all firms with E/P (earnings divided by price) that are less than twice the AAA bond yield.

Like Dr. Perritt, I have no real issue with the first two screens. The last two are a bit stringent, though, and don't account for various types of industries or future growth in a business. What do you think of them?

As you can see, while Graham's equation is a decent place to start looking at a business, it's not perfect by any means. My goal with this column, and hopefully all future columns, is to keep the valuation torch (that Mike and Rich have lit in recent months) alive in Rule Maker land. I started today with Graham's equation, but we can't stop there. Discounted cash flow analysis is out there, along with other concepts such as "real options" that we need to consider.

In the weeks to come, we need to look at each of the companies in the portfolio, decide if they are still Rule Makers, if they still represent compelling value over the long-term, and if not, what our exit strategy needs to be. We also need to start talking about sell strategy for all stocks. When should we sell?

I challenge each of you to start thinking carefully about these issues and to share your thoughts on our Rule Maker Strategies board. Who wants to run Graham's equation and filter on all of the Maker companies? Who wants to run DCF analyses on the group to see how they compare? What other measures of valuation do YOU think we should be looking at?

We have lots of work to do, and the volatile market conditions may be presenting "baby and bath water" opportunities for us. Let's get to it!

David Forrest always shares his doughnuts. To see his holdings, visit his online profile. The Motley Fool is investors writing for investors.

Rule Maker Portfolio

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 Ticker Company Price Change Daily Price % Change Price MSFT MICROSOFT CORPORATION (0.73) (1.24%) 58.15 NOK NOKIA 0.21 1.03% 20.51 YHOO YAHOO! INC. (0.21) (1.89%) 10.88 AXP AMERICAN EXPRESS COMPANY (0.09) (0.3%) 29.43 SGP SCHERING-PLOUGH CORPORATION (0.13) (0.35%) 37.18 INTC INTEL CORPORATION 0.88 3.74% 24.42 PFE PFIZER INC (0.55) (1.3%) 41.90 CSCO CISCO SYSTEMS, INC. 0.35 2.11% 16.92 TROW PRICE T ROWE GROUP INC (0.09) (0.32%) 27.76 KO THE COCA-COLA COMPANY (0.28) (0.58%) 47.88 JNJ JOHNSON & JOHNSON 0.06 0.10% 57.91
 Trade Date # Shares Ticker Cost/Share Price Total % Ret 02/03/98 59 MSFT 49.35 58.15 33.12% 02/15/00 132 NOK 40.21 20.51 -47.08% 02/17/99 106 YHOO 57.60 10.88 -75.78% 05/26/98 95 AXP 35.38 29.43 -15.81% 08/21/98 44 SGP 47.99 37.18 -22.24% 02/13/98 147 INTC 27.44 24.42 -3.51% 02/03/98 66 PFE 27.43 41.90 53.41% 06/23/98 182 CSCO 24.72 16.92 -3.46% 02/03/98 75 TROW 34.12 27.76 -18.34% 02/27/98 27 KO 69.11 47.88 -30.42% 04/03/01 10 JNJ 43.65 57.91 32.67%
Trade Date # Shares Ticker Total Cost Current Value  Total Gain
02/03/98 59 MSFT 2,911.79 3,430.85  519.06
02/15/00 132 NOK 5,307.79 2,707.32  -2,600.47
02/17/99 106 YHOO 6,105.74 1,153.28  -4,952.46
05/26/98 95 AXP 3,360.87 2,795.85  -565.02
08/21/98 44 SGP 2,111.70 1,635.92  -475.78
02/13/98 147 INTC 4,033.23 3,589.74  -443.49
02/03/98 66 PFE 1,810.57 2,765.40  954.83
06/23/98 182 CSCO 4,498.76 3,079.44  -1,419.32
02/03/98 75 TROW 2,559.06 2,082.00  -477.06
02/27/98 27 KO 1,865.89 1,292.76  -573.13
04/03/01 10 JNJ 436.50 579.10  142.60
 Cash: 1,616.00 Total: 26,727.66

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 Notes The Rule Maker Portfolio began with \$20,000 on February 2, 1998, and it added \$2,000 in August 1998 and February 1999. Beginning in July 1999, \$500 in cash (which is soon invested in stocks) is added every month.