Graham Number: Value Stocks Forcing Short-Sellers to Rush for the Exits

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," strongly 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 (EPS) and current book value per share (BVPS).

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.

For our list of ideas, we started with a universe of stocks that have seen a significant decrease in shares shorted over the last month. Short sellers bet on stocks to lose value, so if they're covering their positions, it indicates that they think the upside potential of these stocks outweigh the downside.

To refine the screen, we only focused on stocks that are trading at steep discounts to their fair value, as determined by the Graham number.

Short sellers seem to agree with the Graham equation -- these stocks appear to be deeply undervalued. What do you think? Click here to access free, interactive tools to analyze these ideas.

1. StanCorp Financial Group (NYSE: SFG): Accident & Health Insurance Industry. Trailing 12 month diluted EPS at $3.71, and most recent BVPS at $41.9, implies a Graham Number value at $59.14. Based on Friday's close at $42.92, this implies a potential upside of 37.79%. Over the last month, shares shorted have decreased from 1.98M to 1.71M, a change that is equivalent to 0.60% of the company's float of 44.92M shares.

2. Tele Norte Leste Participacoes (NYSE: TNE): Telecom Services Industry. Trailing 12 month diluted EPS at $1.19, and most recent BVPS at $17.87, implies a Graham Number value at $21.87. Based on Friday's close at $16.55, this implies a potential upside of 32.17%. Over the last month, shares shorted have decreased from 5.43M to 4.54M, a change that is equivalent to 2.37% of the company's float of 37.48M shares.

3. W.R. Berkley (NYSE: WRB): Property & Casualty Insurance Industry. Trailing 12 month diluted EPS at $2.95, and most recent BVPS at $26.78, implies a Graham Number value at $42.16. Based on Friday's close at $32.59, this implies a potential upside of 29.37%. Over the last month, shares shorted have decreased from 8.76M to 8.08M, a change that is equivalent to 0.59% of the company's float of 114.95M shares.

4. Center Financial (Nasdaq: CLFC): Savings & Loans Industry. Trailing 12 month diluted EPS at $0.55, and most recent BVPS at $5.66, implies a Graham Number value at $8.37. Based on Friday's close at $6.54, this implies a potential upside of 27.97%. Over the last month, shares shorted have decreased from 1.22M to 1.00M, a change that is equivalent to 0.62% of the company's float of 35.41M shares.

5. Gerdau (NYSE: GGB): Steel & Iron Industry. Trailing 12 month diluted EPS at $0.87, and most recent BVPS at $8.4, implies a Graham Number value at $12.82. Based on Friday's close at $10.18, this implies a potential upside of 25.96%. Over the last month, shares shorted have decreased from 14.70M to 10.12M, a change that is equivalent to 0.56% of the company's float of 815.09M shares.

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 does not own shares of any companies mentioned.