Is This Retailer Cheap, According to Graham?

I recently spent some time dissecting Benjamin Graham's The Intelligent Investor, the seminal book on value investing. Along the way, I talked about the Graham number as a means of valuation when it comes to stocks.  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.

However, a quick check can help determine whether or not a company might be worthy of a look using the teachings of Graham. He said that in an ideal situation, the P/E ratio and P/B ratio multiplied together should not exceed 22.5, with a maximum P/E ratio of 15 and P/B of 1.5. With that in mind, I screened all the stocks of the S&P 500 that met those requirements and was came up with 53 companies. I will be making a CAPScall on most of these companies after comparing them to competitors and their current value in relation to their Graham numbers. Up now is the office-supply superstore Staples (Nasdaq: SPLS).

Who are they?
Staples may be known for its advertising campaign surrounding the "Easy Button," but you might be surprised to learn that it is the number-two internet retailer in America, behind only Amazon.com. Its focus on business customers helps drive revenue, with 80% of its sales coming from those customers. So while you and I might go to the store every once in a while to pick up a ream of paper, America's businesses are ordering in bulk online from Staples.

Its two closest competitors, OfficeMax (NYSE: OMX) and Office Depot (NYSE: ODP) just don't have the size and clout to compete with Staples. Though both recently beat earnings estimates, Staples is clearly dominating. OfficeMax may be partnering with Google to offer quicker shipping, but it's hard to see it competing with the performance of Staples. Furthermore, while Staples was focusing on becoming a player in online retail, Office Depot was testing its associates and focusing on store appearances.

What's it worth?
The three office-supply stores all trade below their current Graham numbers, with Office Depot showing the most upside. However, the relative lack of earnings for both OfficeMax and Office Depot prevent either company from paying dividends, giving Staples another leg up on its competition.

Source: Yahoo! Finance and author's calculations.

Like Staples, OfficeMax and Office Depot use large-format stores, usually placed in larger retail developments. With large stores comes large overhead, thus driving down margins and earnings. But Staples makes up the difference online, and its place as the second-largest online retailer backs up this strategy.

PetSmart and Tractor Supply Company are included on the list because they are specialty retailers, which is often how Staples and the like are categorized. Despite appearing overvalued based on its Graham number, PetSmart is expected to grow its bottom line by 16% over the next five years, hopefully closing the gap. Tractor Supply is also seemingly overvalued, but the stock is up over 9% since fourth-quarter sales exceeded expectations.

Accountability time
Staples may not have a lot of room to grow right now, but its rank as the second-largest online retailer bears watching. Therefore, I will be placing a "thumbs-up" over on my CAPS page in order to track this call and keep myself accountable, though the company will be capped out at its current Graham number. I also will be adding Staples to MyWatchlist to stay up to date on anything that may cause me to change my opinion of the company.

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