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 |
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 |
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 |
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 |
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 |
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 |
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.
