What is Graham Number in stock?

The Graham Number is a financial concept developed by Benjamin Graham, who is considered the father of value investing and the mentor of Warren Buffett. It is a calculation to determine the intrinsic value of a stock by taking into account both the company's earnings per share (EPS) and its book value per share (BVPS).

The Graham number serves as a valuable tool for defensive investors, who are willing to invest in the stock market. This method facilitates the stock price for any company, regardless of its scale or sector. The Graham number is instrumental in identifying undervalued stocks, thereby presenting an opportunity for investors to make informed decisions. By leveraging this valuation metric, investors tend to potentially acquire stocks trading below their intrinsic value, thus optimizing their investment portfolios.

Graham Number Formula

The formula for the Graham Number is: 

Graham Number =22.5 × Earnings per Share × Book Value per Share

Let's break down each component:

• Earnings per share: This is the portion of a company's profit allocated to each outstanding share of common stock. It is calculated by dividing the company's net income by the total number of outstanding shares. EPS reflects the profitability of the company on a per-share basis.
• Book Value per Share: Also known as shareholders' equity per share, this represents the portion of a company's net assets attributable to each outstanding share. It is calculated by dividing the company's total equity by the total number of outstanding shares. Book value per share indicates the intrinsic value of the company's assets.
• 22.5: Benjamin Graham determined through his analysis that a fair price-to-earnings (P/E) ratio for a value stock is around 15 and a fair price-to-book (P/B) ratio is around 1.5. Multiplying these two values gives approximately 22.5, which he used as a multiplier in the formula.

The Graham Number essentially combines both the earnings and asset-based valuation metrics into one figure. By taking the square root of the product of EPS and Book Value per Share, it provides a rough estimate of the maximum price an investor should pay for a stock and still attain a reasonable rate of return.

Graham Number Calculator

Ms. A, opts to deploy the Graham number calculator as a metric to assess the potential worthiness of acquiring shares in ABC Co. Ltd. Despite her limited capacity to drive deeply into the company's financial intricacies, she adopts a defensive investment stance. ABC Co. Ltd. reported an annual income of INR 40, 00,000, with shareholders' equity amounting to INR 600,000 and 500,000 shares outstanding. Ms. A calculates the Graham number for ABC Co. Ltd. through these parameters.

Earnings Per Share = Net income ÷ No. Of outstanding shares

• Earnings per Share = 40, 00,000 ÷ 5, 00,000
• The profit per share is INR 8.

Book Value per Share = Shareholder's equity ÷ No. Of shares outstanding

Book Value Per Share = 6, 00,000 ÷ 5, 00,000

The book value per share is INR 1.2.

Graham Number = sqrt

Graham Number = 14.6969

Ms. A should acquire this stock if it trades below INR 14.6969. However, stock trading above INR 14.6969 is considered to be overvalued and should not be carried out.

Advantages of Graham Number 

Conservative Valuation:

The Graham number employs a conservative approach to valuation, focusing on tangible factors like earnings per share and book value per share. This can provide a more stable and reliable estimate of a stock's intrinsic value, particularly for value investors who prioritize safety and downside protection. 

Margin of Safety:

One of the key principles of Graham's investment philosophy is investing with a margin of safety. The Graham number fundamentally builds in this margin of safety by using a relatively conservative multiplier (typically 22.5) in its calculation. This helps protect investors from downside risk and provides a cushion against potential losses.

Simplicity:

The formula for calculating the Graham number is simple to understand, making it accessible to individual investors who may not even have advanced financial modeling skills. It provides a quick and simple way to assess whether a stock is undervalued or overvalued based on fundamental metrics.

Long-Term Focus: 

Graham encouraged a long-term investment horizon and a focus on the underlying fundamentals of a company. The Graham number aligns with this approach by emphasizing fundamental metrics like earnings and book value, which are likely to drive long-term value creation.

Disadvantages of Graham Number

Limited Scope: 

The Graham Number relies solely on earnings per share and book value per share to estimate intrinsic value. While these are important fundamental metrics, they may not capture all relevant factors that can affect a stock's value, such as future growth prospects, competitive advantages, or industry dynamics. 

Market Evolution: 

The stock market has evolved since Benjamin Graham's time, with changes in accounting standards, investor behavior, and market dynamics. The Graham Number was developed in a different era and may not fully account for these changes. As a result, investors may need to complement it with additional valuation methods and qualitative analysis to make informed investment decisions.

Dependency on Historical Data:

The Graham Number relies on historical financial data, such as past earnings and book value, to estimate fundamental value. While historical data can provide valuable insights into a company's past performance, it may not fully reflect prospects or changes in the business environment. As a result, investors should use the Graham Number in their investment decision-making process.

Conclusion
The Graham number provides an estimate of a stock's intrinsic value, considering both earnings and assets. Its importance in the stock market lies in its ability to help investors identify potentially undervalued stocks, offering a margin of safety in investment decisions. By comparing a stock's current price to its Graham number, investors can make more informed choices, reducing the risk of overpaying for a stock and increasing the likelihood of long-term returns.