Valuing the Biggest and the Best

One of the big benefits of writing articles for the whole world to see is that sometimes the world is going to write you back. A few weeks ago, I received an email from a nice gentleman who had been searching through the Fool archives and discovered a piece I wrote several years ago about Benjamin Graham's stock valuation formula.

I encourage you to read the previous article to learn about the component pieces, but as a point of reference, I'll repeat the equation here. I warn you, it won't make much sense without reading the prior article, but here goes:

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

In my original article, I wrote that the "4.4" part of the equation represented what Ben Graham required as a rate of return on his money over inflation. My friend, we'll call him "Mr. D," pointed out that I didn't get this quite right. Mr. D tells me that 4.4 was simply the yield on AAA corporate bonds at the time. Further, Mr. D informs me that the last part of the equation (4.4/AAA yield) wasn't part of Graham's original equation at all, but added in later (he thinks by Janet Lowe). Sure enough, he's correct.

You see, Graham originally believed that a stock with no growth should return 11.76% annually, and trade at a P/E of no more than 8.5. (1/8.5=11.76) He arrived at this figure by looking at historical returns for zero-growth stocks.

Knowing that the AAA bond yield was 4.4 % at the time of Graham's writing, and knowing that he required an 11.76% return for zero-growth stocks, we can easily calculate the risk premium he demanded in order to invest in stocks at all. In other words, how much extra return did Graham require of a zero-growth stock to make it worth his while, relative to the highest-grade bonds of the day? Just subtract 4.4% from 11.76% and you have your answer: 7.36%. This was the equity risk premium of the day, at least as far as Benjamin Graham was concerned.

In order to account for changing interest rates, the second part of the equation was later added as a qualifier of sorts. "4.4/AAA corporate bond yield" was introduced to affect the multiplier as bond yields rose above or below the 4.4% of Graham's time.

Just when I thought I had things squared away, Mr. D threw a monkey wrench in my operation. He suggested that the equity risk premium is no longer the 7.36% that Graham required. A more volatile interest rate environment (at the hands of the Federal Reserve) and a more stable U.S. economy (relative to the 1930s and 1940s) have caused the equity risk premium to shrink quite a bit.

The somewhat surreal part of my interaction with Mr. D is that, along the way, he forwarded me an email from Princeton professor Burton Malkiel. Of course, Malkiel is the famous author of A Random Walk Down Wall Street, and his Efficient Market Theory is one of the most debated in all of investing.

Apparently Mr. D dropped his friend Burton a note and asked him what he thought the equity risk premium was these days. Assuming the person truly is Malkiel (I have not authenticated but have no reason to doubt), Dr. Malkiel believes the current equity risk premium is about 3% and nowhere near the 7.36% above AAA bonds that Graham required. Wow. The implications for stock valuation are significant.

Adding 3% to the current AAA bond yield of 5.4%, we get 8.4%. If it's true -- due to more volatile interest rates and a dominant U.S. economy -- that investors should only require 8.4% instead of 12% for zero-growth stocks, then the 8.5 in our equation now becomes 12. Talk about role reversal!

Gentle reader, I realize that many of you are about to scratch your eyes out, wondering where the heck I'm going with all of this. Well, all of this mathematical hooey is relevant to you because Ben Graham's formula is a useful tool to help you understand the valuation of your favorite companies. Don't disrespect the numbers, bub, or you'll end up on the wrong side of a bubble bursting. Ya feel me, playah?

Now that you're equipped with just enough information to shoot yourself in the foot, let's start firing, shall we? I took a look at seven of the most prominent companies of today and ran them through Graham's value equation.

According to Graham's equation, and factoring in Malkiel's suggested equity risk premium, Microsoft should be fairly valued at $32.91. This would indicate that Microsoft is 13.5% undervalued right now.

With a current price of just $34.14, is GE a steal?

Intel is only trading at $32.43, a full 50% below what this model suggests as its fair value. That said, my concern is that Intel has been wildly inconsistent over the past few years in its financial performance, so trusting future projections from analysts might not be the best idea with this one.

With Amazon trading at $57 or so, this model would give it a big thumbs down from a valuation standpoint.

Oddly enough, this puts Yahoo! at just about the right price, with stubs of the Internet behemoth trading around $48.16 these days. Still, this is another stock with shaky performance these past years, so I'm a little leery of analyst estimates here.

Like Yahoo!, shares of Coke are trading very close to Graham's equation for fair value.

Is it possible that David Gardner's pick from The Motley Fool Stock Advisor newsletter, already up 100% since it was recommended, is still 33% undervalued? Shares today are only trading around $68.

I'll be the first one to tell you that there is no magic bullet or black box in investing. Graham's equation isn't the end-all-be-all, but it's a great beginning for someone who is trying to wrestle with the valuations of the stocks in her portfolio. I encourage you to become more familiar with this equation, re-read my piece from 2001, and start having some fun doing your own math. And, if you have questions or comments about this article, feel free to email me at [email protected]. See you next week. Same Bat time, same Bat channel.

David Forrest doesn't own any of the stocks discussed in this article but he does like to snack on the Atkins low-carb peanut butter and chocolate wafer candy bars. Only 4 net carbs and they taste great! Who knew?