Benjamin Graham's Stock Valuation

Equation
Ben Graham's Equation

Benjamin Graham, considered by most to be the father of value investing, offered a

valuation equation designed to help estimate what a growth company is worth. The
formula is by no means a magic bullet, but it does give us a good place to start when
looking at the valuations for Rule Makers.

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By David Forrest (TMF Bogey)

October 31, 2001

Tomorrow is All Saints Day, and what better way to spend this column than talking a bit
about the patron saint of value investing, Benjamin Graham? Okay, Mr. Graham isn't really
a patron saint, but many consider him the father of value investing, and he's someone we
can look to for guidance on how to value a business.

For those who follow Berkshire Hathaway (NYSE: BRK.A) and legendary investor Warren
Buffett, you know that Buffett was a student of Graham. You also know that Graham
penned two very famous investment tomes, Security Analysis (with David Dodd) and The
Intelligent Investor. Of the two, The Intelligent Investor is a little easier to digest, but both
are must-haves for any investing library.

In The Intelligent Investor, Graham laid out an equation that was designed to help people
value a growth company. The equation goes like this:

P = ProjEPS * (8.5 + (2*G)) * (4.4/AAA yield)

Looks scary, but it's not. Let me break it down for you.

P = the price of the company's stock. This is what the equation will tell you.

ProjEPS = the projected earnings per share. You're looking for next year's estimated
earnings per share. (Get estimates here.)

8.5
Graham surmised that a zero growth stock should have a P/E multiple of 8.5. This reflects
an average return of 12% per year. For what it's worth, I think this is a little shaky given the
wide variety of circumstances leading to a company with zero growth. As you'll see,
Graham put some qualifiers on this equation.

2*G
G is the long-term projected growth rate of a company's EPS. Graham said that you
should be comfortable that the company will grow its earnings at this rate over the next
seven to 10 years. Unfortunately, most companies/analysts only give 5-year expected
growth rates, so you'll have to use those.

4.4
This was Graham's benchmark for a required rate of return to invest, period. He surmised
that at a minimum, an investor needed to be compensated for the effects of inflation and a
small risk premium above that. You might be tempted to "play around" with the 4.4, but I
keep it constant.

AAA yield
This is the yield on the AAA corporate bonds. I like to use the 30-year composite yields,
but they are difficult to find. Here is a link that's a few weeks dated, but it'll serve for now:
http://www.bondresources.com/Corporate/Rates/AAA

The 30-year yield on AAA corporate is about 6.25%.

Okay, so what does all this mean and why am I bothering you with it? Last week, I wrote
about risk and expected returns. If you remember, we talked about how investing in one
asset class (stocks vs. bonds vs. CDs, etc.) requires that you receive a greater rate of
return relative to less risky classes. Graham's equation builds in an equity growth premium
as well as an interest rate factor. It's not a magic formula that will solve all of your
problems, but it does provide a decent data point to consider in our evaluation of a
company's stock price. Let's quickly do an example using Pfizer:

P = 1.59 * (8.5 + (2 * 19.5)) * (4.4/6.25)

P = 1.59 * (8.5 + (39)) * (.704)

P = 1.59 * 47.5 * .704

P = $53.16

According to this simple equation, Pfizer's value is about $53. The stock currently trades
around $42.50. If you were to take this as gospel (and you better not), you might conclude
that the stock is about 25% undervalued at current prices.
Why am I so cautious and advising you against using this as your "magic dust"? Well, it's
only one model, it's imperfect, and it doesn't account for a host of other issues a company
may deal with. It also doesn't address other kinds of valuations, such as discounted cash
flow analysis, among others.

Graham provided four major caveats to his equation that I should share here. In the book
Small Stocks, Big Profits, Dr. Gerald Perritt describes these caveats as follows. In
screening stocks, you should:

1. Eliminate all firms with negative earnings (losses).

2. Eliminate all firms with debt to total asset ratios greater than 0.60 (i.e., firms with total
debt greater than 60% of total assets).

3. Eliminate all firms with share prices above net working capital per share.

4. Eliminate all firms with E/P (earnings divided by price) that are less than twice the AAA
bond yield.

Like Dr. Perritt, I have no real issue with the first two screens. The last two are a bit
stringent, though, and don't account for various types of industries or future growth in a
business. What do you think of them?

As you can see, while Graham's equation is a decent place to start looking at a business,
it's not perfect by any means. My goal with this column, and hopefully all future columns, is
to keep the valuation torch (that Mike and Rich have lit in recent months) alive in Rule
Maker land. I started today with Graham's equation, but we can't stop there. Discounted
cash flow analysis is out there, along with other concepts such as "real options" that we
need to consider.

In the weeks to come, we need to look at each of the companies in the portfolio, decide if
they are still Rule Makers, if they still represent compelling value over the long-term, and if
not, what our exit strategy needs to be. We also need to start talking about sell strategy for
all stocks. When should we sell?

I challenge each of you to start thinking carefully about these issues and to share your
thoughts on our Rule Maker Strategies board. Who wants to run Graham's equation and
filter on all of the Maker companies? Who wants to run DCF analyses on the group to see
how they compare? What other measures of valuation do YOU think we should be looking
at?

We have lots of work to do, and the volatile market conditions may be presenting "baby
and bath water" opportunities for us. Let's get to it!

David Forrest always shares his doughnuts. To see his holdings, visit his online profile.
The Motley Fool is investors writing for investors.

Posted by editor on 30 January 2004 07:16 PM | TrackBack

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See also:
• AturMaju Resources Berhad - KLSE Stock Research Report - 30 Jan 2004
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New world growth stock valuation using

Graham's formula
Valuing the Biggest and the Best

Benjamin Graham, the father of value investing, left us with a simple equation to help
value growth stocks. With some help from an email friend and Burton Malkiel, David
Forrest applies some old-school thinking to today's new-world companies. You may be
surprised at the results.

By David Forrest (TMF Bogey)

January 27, 2004

One of the big benefits of writing articles for the whole world to see is that sometimes the
world is going to write you back. A few weeks ago, I received an email from a nice
gentleman who had been searching through the Fool archives and discovered a piece I
wrote several years ago about Benjamin Graham's stock valuation formula.

I encourage you to read the previous article to learn about the component pieces, but as a
point of reference, I'll repeat the equation here. I warn you, it won't make much sense
without reading the prior article, but here goes:

Price = ProjEPS * (8.5 + (2*G)) * (4.4/AAA yield)

In my original article, I wrote that the "4.4" part of the equation represented what Ben
Graham required as a rate of return on his money over inflation. My friend, we'll call him
"Mr. D," pointed out that I didn't get this quite right. Mr. D tells me that 4.4 was simply the
yield on AAA corporate bonds at the time. Further, Mr. D informs me that the last part of
the equation (4.4/AAA yield) wasn't part of Graham's original equation at all, but added in
later (he thinks by Janet Lowe). Sure enough, he's correct.

You see, Graham originally believed that a stock with no growth should return 11.76%
annually, and trade at a P/E of no more than 8.5. (1/8.5=11.76) He arrived at this figure by
looking at historical returns for zero-growth stocks.

Knowing that the AAA bond yield was 4.4 % at the time of Graham's writing, and knowing
that he required an 11.76% return for zero-growth stocks, we can easily calculate the risk
premium he demanded in order to invest in stocks at all. In other words, how much extra
return did Graham require of a zero-growth stock to make it worth his while, relative to the
highest-grade bonds of the day? Just subtract 4.4% from 11.76% and you have your
answer: 7.36%. This was the equity risk premium of the day, at least as far as Benjamin
Graham was concerned.

In order to account for changing interest rates, the second part of the equation was later
added as a qualifier of sorts. "4.4/AAA corporate bond yield" was introduced to affect the
multiplier as bond yields rose above or below the 4.4% of Graham's time.

Just when I thought I had things squared away, Mr. D threw a monkey wrench in my
operation. He suggested that the equity risk premium is no longer the 7.36% that Graham
required. A more volatile interest rate environment (at the hands of the Federal Reserve)
and a more stable U.S. economy (relative to the 1930s and 1940s) have caused the equity
risk premium to shrink quite a bit.

The somewhat surreal part of my interaction with Mr. D is that, along the way, he
forwarded me an email from Princeton professor Burton Malkiel. Of course, Malkiel is the
famous author of A Random Walk Down Wall Street, and his Efficient Market Theory is
one of the most debated in all of investing.

Apparently Mr. D dropped his friend Burton a note and asked him what he thought the
equity risk premium was these days. Assuming the person truly is Malkiel (I have not
authenticated but have no reason to doubt), Dr. Malkiel believes the current equity risk
premium is about 3% and nowhere near the 7.36% above AAA bonds that Graham
required. Wow. The implications for stock valuation are significant.

Adding 3% to the current AAA bond yield of 5.4%, we get 8.4%. If it's true -- due to more
volatile interest rates and a dominant U.S. economy -- that investors should only require
8.4% instead of 12% for zero-growth stocks, then the 8.5 in our equation now becomes 12.
Talk about role reversal!

Gentle reader, I realize that many of you are about to scratch your eyes out, wondering
where the heck I'm going with all of this. Well, all of this mathematical hooey is relevant to
you because Ben Graham's formula is a useful tool to help you understand the valuation of
your favorite companies. Don't disrespect the numbers, bub, or you'll end up on the wrong
side of a bubble bursting. Ya feel me, playah?
Now that you're equipped with just enough information to shoot yourself in the foot, let's
start firing, shall we? I took a look at seven of the most prominent companies of today and
ran them through Graham's value equation.

Microsoft (Nasdaq: MSFT)

P = $1.27*(12+(2*10))*(4.4/5.4)

P = $1.27*32*.81

P = $32.91

According to Graham's equation, and factoring in Malkiel's suggested equity risk premium,
Microsoft should be fairly valued at $32.91. This would indicate that Microsoft is 13.5%
undervalued right now.

General Electric (NYSE: GE)

P = $1.76*(12+(2*10))*(4.4/5.4)

P = $1.76*32*.81

P = $45.61

With a current price of just $34.14, is GE a steal?

Intel (Nasdaq: INTC)

P = $1.47*(12+(2*15))*(4.4/5.4)

P = $1.47*42*.81

P = $50.00

Intel is only trading at $32.43, a full 50% below what this model suggests as its fair value.
That said, my concern is that Intel has been wildly inconsistent over the past few years in
its financial performance, so trusting future projections from analysts might not be the best
idea with this one.

Amazon.com (Nasdaq: AMZN)

P = $0.88*(12+(2*30.2))*(4.4/5.4)

P = $0.88*72.4*.81

P = $51.60

With Amazon trading at $57 or so, this model would give it a big thumbs down from a
valuation standpoint.

Yahoo! (Nasdaq: YHOO)

P = $0.75*(12+(2*35))*(4.4/5.4)

P = $0.75*82*.81

P = $49.81

Oddly enough, this puts Yahoo! at just about the right price, with stubs of the Internet
behemoth trading around $48.16 these days. Still, this is another stock with shaky
performance these past years, so I'm a little leery of analyst estimates here.

Coca-Cola (NYSE: KO)

P = $2.10*(12+(2*10.1))*(4.4/5.4)

P = $2.10*32.2*.81

P = $54.77

Like Yahoo!, shares of Coke are trading very close to Graham's equation for fair value.

eBay (Nasdaq: EBAY)

P = $1.44*(12+(2*37.5))*(4.4/5.4)

P = $1.44*87*.81

P = $101.47

Is it possible that David Gardner's pick from The Motley Fool Stock Advisor newsletter,
already up 100% since it was recommended, is still 33% undervalued? Shares today are
only trading around $68.

I'll be the first one to tell you that there is no magic bullet or black box in investing.
Graham's equation isn't the end-all-be-all, but it's a great beginning for someone who is
trying to wrestle with the valuations of the stocks in her portfolio. I encourage you to
become more familiar with this equation, re-read my piece from 2001, and start having
some fun doing your own math. And, if you have questions or comments about this article,
feel free to email me at davidf@fool.com. See you next week. Same Bat time, same Bat
channel.

David Forrest doesn't own any of the stocks discussed in this article but he does like to
snack on the Atkins low-carb peanut butter and chocolate wafer candy bars. Only 4 net
carbs and they taste great! Who knew?