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Using The Graham Number Correctly

Oct. 4, 2012 4:08 PM ET13 comments
by: Serenity

One of the most commonly used stock selection formulas these days is the Graham
Number, which Graham actually did recommend (unlike the completely misunderstood
Benjamin Graham Formula).

But again, there is a very large difference between how this calculation was
recommended, and how it is being used today.

The Derivation:

The number itself is simple enough, and can be derived from criteria [6] and [7] from
Graham's calculations for defensive stocks.

Summarized from CHAPTER 14 of The Intelligent Investor - Stock Selection for the
defensive Investor:

1. Not less than $100 million of annual sales.

[Serenity note: This comes to $500 million today based on the difference in
CPI/Inflation from 1973]

2. (A) Current assets should be at least twice current liabilities.

2. (B) Long-term debt should not exceed the net current assets.

3. Some earnings for the common stock in each of the past ten years.

4. Uninterrupted payments for at least the past 20 years.

5. A minimum increase of at least one-third in per-share earnings in the past ten

years.

6. Current price should not be more than 15 times average earnings.

7. Current price should not be more than 1-¹⁄ times the book value.

As a rule of thumb we suggest that the product of the multiplier times the ratio of
price to book value should not exceed 22.5.
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The optimum price for a defensive stock can easily be derived from this as the square root
of (22.5 x EPS x BVPS), and this is the Graham number.

The problem however is that almost everywhere today, this number is used alone, while
the other 5 supporting criteria for defensive stock selection are completely ignored.

The Complete Procedure:

The complete stock selection procedure recommended by Graham is far more elaborate.

Step 1. First a stock is checked against all 7 criteria for defensive investment above.

Step 2. If the stock fails to meet any one of the above criteria, it is then checked against
the 5 criteria for Enterprising investment (below).

Summarized from CHAPTER 15 of The Intelligent Investor - Stock Selection for the
Enterprising Investor:

[Serenity note: For issues selling at PE multipliers under 10]

1. Current assets at least ¹¹⁄ times current liabilities.

1. Debt not more than 110% of net current assets.

2. Earnings stability: No deficit in the last five years covered in the Stock Guide.

3. Dividend record: Some current dividend.

4. Earnings growth: Last year's earnings more than those of 1966.

[Serenity note: This corresponds approximately to the earnings of 2007 today]

5. Price: Less than 120% net tangible assets.

This second set of criteria gives us an optimum price for a stock meeting the above
conditions (an "enterprising" stock) as - the lower of 120% net tangible assets (book
value), or 10 times current earnings.

This is a number quite different from the Graham Number, but equally, if not more valuable
today.

Step 3. If a stock meets neither of the above groups of checks, it is finally checked against
the last 2 criteria for investment as an NCAV or "bargain" stock (below).

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Summarized from CHAPTER 15 of The Intelligent Investor - Stock Selection for the
Enterprising Investor:

"Bargain Issues, or Net-Current-Asset Stocks"

"price less than the applicable net current assets alone-after deducting all prior
claims, and counting as zero the fixed and other assets."

"eliminated those which had reported net losses in the last 12-month period."

This last set of criteria, for a stock that meets neither of the first 2 sets of criteria, gives us
an NCAV stock. This is a stock selling for less than the value of its cash worth alone, and
with positive earnings (no losses) in the last one year.

For a complete understanding of stocks and investing, a reading of "The Intelligent

Investor" by Benjamin Graham is highly recommended. This is the book that Warren
Buffett himself describes (in the Preface) as "by far the best book about investing ever
written."

To Conclude:

If one were to apply all the Graham defensive criteria strictly, using 500 million in sales to
count for inflation since 1973, there are plenty of stocks that meet most of them.

But they're all either too expensive, or don't meet the dividend criteria.

For example, these stocks meet all the defensive quality criteria but are simply too
expensive:

Stock Symbol Sales Earnings growth Graham Number Current price

Intel Corp INTC 125.23% 102.28% $22.41 $22.66

Cato Corp A CATO 102.22% 100.22% $25.87 $29.71

Fuller, H.B. Co FUL 104.89% 100.48% $24.24 $30.68

Valmont Industries Inc VMI 107.73% 100.75% $94.51 $131.50

SEI Investments Corp SEIC 102.21% 100.22% $12.25 $21.44

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Lancaster Colony Corp LANC 103.03% 100.30% $41.83 $73.25

Sigma-Aldrich Corp SIAL 107.42% 100.72% $40.05 $71.97

Henry, Jack & Associates JKHY 102.41% 100.24% $20.07 $37.85

T Rowe Price Group Inc TROW 107.91% 100.76% $30.59 $63.30

Fastenal Co FAST 107.95% 100.77% $11.90 $42.99

And these stocks meet all the defensive criteria, including the pricing ones, but have a
dividend record of less than 20 years:

Stock Symbol Sales Dividend Earnings Graham Current

record growth Number price

Bunge Ltd BG 125.76% 55.00% 102.32% $104.59 $67.05

Murphy Oil Corp MUR 121.13% 60.00% 101.94% $63.45 $53.69

Molson Coors Brewing TAP 109.25% 60.00% 100.89% $59.32 $45.05

Co B

Alamo Group Inc ALG 100.03% 60.00% 100.00% $38.21 $33.78

Autoliv Inc ALV 113.99% 60.00% 101.32% $75.62 $61.97

HollyFrontier HFC 117.63% 65.00% 101.64% $59.91 $41.27

Corporation

Brady Corporation BRC 104.10% 60.00% 100.40% $30.31 $29.28

Occidental Petroleum OXY 120.28% 60.00% 101.86% $93.59 $86.06

Chevron Corp CVX 135.30% 60.00% 103.07% $138.69 $116.56

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Graham's various criteria are a fine balance of checks. There's no point if a stock meets
just some of the criteria in a group and doesn't meet others.

For example, it's easy for a stock to show a great asset number while having lots of debt.

An automated analysis of all 4000 NYSE and Nasdaq stocks today did not bring up any
stocks meeting all the defensive criteria (using sales figures compensated for inflation).
But there are plenty of stocks meeting all the necessary Enterprising and NCAV criteria.

In the end, choosing stocks that completely meet one of the latter two groups of Graham
criteria is a far better approach, than investing in stocks that incompletely meet the
defensive criteria.

And just using the Graham Number, which satisfies only 2 of the 7 defensive criteria, is not
only excessively simplistic, but also potentially dangerous.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any
positions within the next 72 hours. I wrote this article myself, and it expresses my own
opinions. I am not receiving compensation for it. I have no business relationship with any
company whose stock is mentioned in this article.

Additional disclosure: The lists of stocks were arrived at by automated quantitative

analysis and were not verified individually. Check for any recent changes in the data used
before making an investment decision, especially for any recent stock splits.

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Comments (13)

keylay31
Hi Serenity,
Your website has indeed been updated and it's clear your LinkedIn and Facebook articles follow Graham by using
Current Assets. The issue was my mistake. For AAPL, you list a "Last Updated" time of 1 day, yet the data is
"Submitted by Serenity on Fri, 2012-06-22 01:49". When looking at AAPL's May NCAV, it is almost exactly the same
as AAPL's November NTAV (Total Assets), by coincidence. Needless to say, its clear your calculations are accurate.
Thank you for the service you are providing and the excellent clarity in this article.

27 Nov 2012, 02:37 AM

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Serenity
Author’s reply » Thank you, keylay31!

Please don't hesitate to ask if you have any more questions.

27 Nov 2012, 06:03 AM

keylay31
I emailed you concerning this issue, but did not get a satisfactory response. For NCAV, you appear to use Total
Assets in your calculation. I have a copy of the Intelligent Investor in my hands, and Graham suggests using Total
Current Assets only. (Thus the name "Net Current Assets Value". Can you comment on why you use Total Assets
instead?

An additional issue. On your website, you list Good/Enterprising grade as calculated as the lower of 120% net
tangible assets, or a PE of 9. Yet here in your article you quote a PE of 10. You need to clarify and fix these
inconsistencies.

25 Nov 2012, 04:24 PM

Serenity
Author’s reply » Hello keylay31,

First of all, thank you for your feedback!

Serenity calculates all Enterprising stocks using a PE of 10, as mentioned here, and on most places in the
website. Any instance of the PE being mentioned as "9" is a content error and should already have been
corrected. The content error will not affect the calculations in the database in any way. The PE for enterprising
stocks has always been calculated using a value of 10.

Regarding your original query, as mentioned in the email reply, Serenity does not use Total Assets for
calculating the NCAV value. Serenity's database does not even store Total Assets for a stock since it is not
required for Graham's calculations.

Graham did recommended [Current Assets - Total Liabilities] for NCAV calculations, as you said, and that is
what is used on Serenity's database too.

Hope this answers your questions.

Thank you for your time!

26 Nov 2012, 07:18 AM

Joe Ontario
G Ray - From XRTX's Oct 2nd press release: Tangible BV=$16.08. Q3 EPS = $0.29. Assuming they will have the
same EPS for the next 4 quarters, the Graham number will be = $20.49. Even if their EPS is as low as $0.15 per
quarter, the Graham number is still $14.73. I am buying at the current price level.

05 Oct 2012, 03:26 PM

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Joe Ontario
An very good article, thanks. It reminds me the principles that Graham wrote.

I use Graham number to manage my portfolio for consistency purposes. I buy the equity if the price is at or below
Graham number and I add other criteria: should pay dividend, price is less than 10% from 52 weeks low and
sustainable business model. Most of the time the book value that I use is the tangible book value. I will sell the equity
when it is 30% above the Graham number.

I am happy with the results.

Disclosure: bought XRTX yesterday because it meets my buying criteria.

05 Oct 2012, 09:16 AM

G.Ray
Marketplace
Joe O--Xyratex expects to report net income between $0.15 a share to $0.43 a share on $235 million to $285
million in revenue. That is a wildly wide range. Do they know what they are doing? The problem though is that
even the high end of its range is well short of the $0.49 a share in earnings and $328 million in revenue that
analysts were forecasting. Good luck on that.

05 Oct 2012, 11:20 AM

Serenity
Author’s reply » Thank you, Joe Ontario!

If you require, Serenity already has a screener for finding stocks that meet the Graham Number and other
individual Defensive criteria - completely or partially.
Link: http://bit.ly/PFBPiL

But Serenity's recommended screener is the "Comprehensive Graham" screener, which shows you all stocks
meeting all of Graham's criteria - Defensive, Enterprising and NCAV!
Link: http://bit.ly/QYCMaj

05 Oct 2012, 04:27 PM

Serenity
Author’s reply » Graham is never wrong but his principles are rarely applied correctly (as demonstrated in this article
itself).
The market is rarely right!

Quoting from Buffett's preface to Graham's book:

"Whether you achieve outstanding results will depend on the effort and intellect you apply to your investments, as well
as on the amplitudes of stock-market folly that prevail during your investing career. The sillier the market’s behavior,
the greater the opportunity for the business-like investor. Follow Graham and you will profit from folly rather than
participate in it."

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And from Buffett's remembrance about Graham:

"In an area where much looks foolish within weeks or months after publication, Ben’s principles have remained sound
—their value often enhanced and better understood in the wake of financial storms that demolished flimsier
intellectual structures. His counsel of soundness brought unfailing rewards to his followers"

05 Oct 2012, 12:20 AM

Philip Mause
Contributor
HPQ sure looks good based on these metrics. The only problem is that I read a book using Graham metrics and in
the early 2000s it screened Washington Mutual as one of the only stocks meeting the test - ugh! I think the test is a
good screener but then you have to figure out why the market doesn't like the stock and whether the market is right or
wrong.

04 Oct 2012, 04:19 PM

Serenity
Author’s reply » Philip Mause,

The reply to your comment is given below.

Thank you.

05 Oct 2012, 04:29 PM

Whitehawk
"I think the test is a good screener ***but then you have to figure out why the market doesn't like the stock
and whether the market is right or wrong.***"

Couldn't agree more. This (right, wrong or indifferent) involves "intangibles" such as sentiment. The market
may continue to ignore the merits of a good value stock. Or there may be issues not -yet- reflected in the
financial metrics that render the stock a value trap (as many view HPQ to be).

17 Oct 2012, 12:45 PM

Serenity
Author’s reply » Thank you, Whitehawk!

Graham's core philosophy is that the market operates more on emotion (sentiment) than reason. The market
changes its evaluation of a stock several 100 times a year, sometimes drastically! But the inherent quality of a
stock changes only once, or maybe twice, a year.

Graham taught that, by having an objective and detailed way to measure the inherent quality of a stock in its
present state, one can identify when the market is behaving excessively irrationally (sentimentally) and take
advantage of the situation.

This difference between the rational and the irrational, is called the margin of safety.

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The trick is to be a step ahead, by doing a more detailed analysis than everyone else. If you have maintained
a sufficient margin of safety, your diligence will pay off when the market eventually sees reason.

--
Serenity Stocks

05 Dec 2012, 09:41 PM

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