Understanding The Application Of The Graham Formula In The Modern Indian

Context

The Graham formula, also known as the security analysis method, was invented by
Mr.Benjamin Graham and is stated as below:

Intrinsic value = (Average EPS* x (pe†(usually 7 to 8.5) + a‡ x g§))

The formula aims to estimate the intrinsic value of a company on the basis of predicted
earnings of the company over a period of 10 years or so.
In order to better appreciate how this formula was derived, we must first understand what the
PE ratio of a company means.

The P/E ratio is the price at which a certain stock is valued, in terms of its earnings per share
(EPS). Therefore the P/E ratio is the current price of a certain stock divided by the EPS of that
stock. Consequently, if we reverse engineer this ratio we see that when the EPS is multiplied
with the PE ratio, we get the price of the stock at that P/E value.

In the context of the Graham security analysis formula, we observe that Graham uses the
mathematical logic mentioned above in order to determine the intrinsic value of a company.
The P/E ratio of 7 to 8.5 is the value that Graham believed to be appropriate for a zero growth
company and the addition of g is the increase in P/E in proportion to a company’s projected
growth in EPS (we will further elaborate upon this with our examples). If we take a company
X with no growth in EPS, Benjamin Graham says the intrinsic value of that company would be
anywhere between 7 to 8.5 P/E depending on how conservative you are.

Now let us assume company X’s earnings (and by virtue EPS) grows at some rate. He takes
the average growth rate% and adds it to the P/E in order to estimate a fair intrinsic value of
the company at that growth rate%. Depending on external factors, you can change the value
of ‘a’ which is the multiplier. Graham takes the value of ‘a’ as 2 but if you were conservative
you could instead assume the value of ‘a’ to be 1.

Now that we get the estimated intrinsic P/E in terms of future growth, we can now multiply it
with the average EPS in order to get the intrinsic value of the company.

This method of intrinsic value calculation is illustrated clearly with the use of an example:
For our company let us take ITC. First we need data on its EPS records going back ten years**.

YEAR EPS (in rs) Growth %

2009 2.88 -

2010 3.55 23.26

*
Average EPS as mentioned in this formula is the average earnings per share over a period of ten years. The
earnings per share of a company is usually available on the internet. Formula: sum of all the eps from each
year/total no. of years
†
Note: the PE here is the pe of a company which projects zero growth in eps over a period of ten years. Graham
notes it to be anywhere between 7 to 8.5 depending on how conservative the investor is.
‡
The multiplier which can vary between 1 to 2 as discussed in the essay.
§
This is the average growth percentage in eps over a period of 10 years
**
This data is usually available on the internet, https://www.itcportal.com/about-itc/shareholder-value/key-
financials/key-ratios.aspx
 2011 4.30 21.12

2012 5.25 22.09

2013 6.26 19.238

2014 7.36 17.76

2015 7.99 9

2016 8.16 2.13

2017 8.40 2.94

2018 9.20 9.5

2019 10.17 10.54

Average ten year EPS 6.68

Average growth in EPS% (annually) 13.76%

Now let us substitute these numbers into the formula step by step:

Intrinsic value (v) = 6.68 x (7+ (1) x (13.76))

v = 138.6768 rupees
This number above is the most conservative estimate of the value of the stock. If we tweak
the values a bit we see that the intrinsic value changes.
Instead of 7 if the value taken is 8.5 as Graham did and the value of ‘a’ as 2. We see that the
value changes.

V = 6.68 x (8.5+ (2 x 7.168))

V = 240.6136 rupees.

This is the part of the beauty of the formula as it lets the investor decide how much he thinks
the company’s growth should increase based on historic records. It also leaves the investor
to decide what the P/E ratio of a company with zero growth should be. Playing around with
this equation we can see that the intrinsic value of ITC lies anywhere between 139 rupees to
241 rupees.
Now let us take a scenario where the growth rate of ITC in terms of EPS is 0, that is the value
of g in the formula is 0. When this happens we see that the intrinsic value of the company is
just Average EPS multiplied with the P/E ratio the investor decides to attribute as a fair value
(between 7 to 8.5).

Average EPS 6.68

Average growth (hypothetically) 0

V = 6.68 x (8.5+0)
V = 58.48 rupees
If we take the lower P/E number assuming we are conservative:
V = 6.68 x (7)
V = 46.76 rupees
Now we know that if ITC were not to project any growth in the future the ballpark range of its
intrinsic value is anywhere between 46.8 to 58.5 rupees.

We can also use Graham's method of security analysis to assess what growth rate the market
is expecting/speculating in regards to a particular stock.
Consider the scenario where at the current price level of ITC as of 16th april 2020, the price
of one stock of ITC is 189 rupees.
Now if we were to reverse engineer the formula we can predict what the ballpark range of
predicted future growth in EPS is.
Here because the market thinks 189 is the intrinsic value we can take V as 189.
189 = 6.68 (7+g)
Expected annual growth rate of EPS (g) = 21.29%
Now let us take the optimistic investor who takes the multiplier value ‘a’ as 2 and the P/E value
as 8.5.
189 = 6.68 (8.5+2g)
Expected annual growth rate of EPS (g) = 9.89%
This is an interesting observation how the optimistic investor has a lower expected annual
growth rate of EPS, but it makes perfect sense as the optimistic investor’s estimation of
intrinsic value is the same as the conservative investor but the conservative investor only
values it at 189 at a growth rate of 21.29%.
The ballpark estimate of the expected growth rate by the market is anywhere between 9.89%
to 21.29%.

Now let us follow the same steps for another similarly diversified conglomerate, Hindustan
Unilever††:

YEAR EPS (in rs) Growth %

2009 10.10 -

2010 10.58 4.75

2011 12.46 17.76

2012 17.56 40.93

2013 17.88 1.822

2014 19.95 11.577

2015 19.12 -5.41

2016 20.75 9.96

2017 24.20 16.63

††
https://www.hul.co.in/Images/10-year-track-record_tcm1255-537710_1_en.pdf
 2018 27.89 15.24

Average growth % (of EPS) 12.585%

Average EPS 18.02

V = 18.02 x (7 + 12.585)
V = 352.92 rupees

A more optimistic approach:

V = 18.02 x ( 8.5+ 2 x 12.585)
V = 606.73 rupees

Based on the information from the past ten years, we see that Hindustan Unilever’s intrinsic
value should be anywhere from 352.92 rupees to 607.73 rupees.
If HUL were to be a zero growth company, its intrinsic value would be calculated as follows:

V = 18.02 X (8.5)
= 153.17 rupees
A more conservative approach:

V = 18.02 x (7)
V = 126.14 rupees
The ballpark figure for the intrinsic value of Hindustan Unilever if it were a zero growth
company would be anywhere from 126 rupees to 153 rupees.

Now let us calculate the annual growth rate of EPS, which the market forecasts/speculates
will be over the next ten years:

Higher estimate:
2443 = 18.02 x(7+ g )
g = 128.57%
Lower estimate:
2443 = 18.02 x (8.5 + 2g)
g= 63.54%

From this we see that if the market values the stock at 2443, we see that they forecast an
annual growth percentage from anywhere between 63.54% to 128.57%.

The biggest drawback of this method of security analysis is that it leaves a lot of assumptions
to make. As Graham said, it is better to be slightly inaccurate and correct rather than precise
and wrong. Therefore we see that this method of investment value calculation provides the
investor a range rather than one answer. Another point to be addressed is as to why do we
take past data instead of predicting the future. This is because the past information gives a
concrete basis and a direction to go off of. Although we must understand that past data might
not always reflect how a company will do in the future, it gives us a more accurate picture of
the situation from which we may deduce future growth. In the words of Mr. Warren Buffet, “the
rear view mirror is clearer than the windshield”.

Intrinsic value calculation using the Graham method is very useful in determining a good
investment but it should also be noted that a good investment has a plethora of other factors
affecting the quality of the investment. These factors should also be given their due weight
apart from relying on the value arrived at by using the Graham intrinsic value calculation
method.