Understanding the Graham Number
Developed by Benjamin Graham, known as the father of value investing, the Graham Number offers an insight into the maximum fair price a defensive investor might consider paying for a stock without overpaying. It incorporates earnings per share (EPS) and book value per share (BVPS), framed within a formula that multiplies these metrics by 22.5. This magical number of 22.5 isn’t just a ran-dom choice but reflects Graham’s ideal Price-to-Earnings (PE) ratio of 15 and Price-to-Book (PB) ratio of 1.5 — because, as Benjamin famously remarked, “15 times earnings and 1.5 times book are right only when they are right.”
Formula and Calculation
To unearth this legendary number, you whip up the following concoction:
\[ \text{Graham Number} = \sqrt{22.5 \times (\text{EPS}) \times (\text{BVPS})} \]
Dive into the components:
- EPS: The sweet spot of a company’s profitability on a per share basis, showcasing how effectively the firm is turning the gears of its profit-making machine.
- BVPS: A slice of the company’s equity pie, served per outstanding share, giving investors a taste of what each share would be worth if the company decided to settle down and liquidate.
Example in Action
Imagine a company, let’s call it “Gadget Inc.”, with an EPS of $2 and a BVPS of $30. The Graham Number crunches out as:
\[ \text{Graham Number} = \sqrt{22.5 \times 2 \times 30} = \sqrt{1350} \approx $36.74 \]
In this scenario, $36.74 represents the upper crust of what a prudent investor would pay for Gadget Inc.’s shares. If the market price hovers below this, it’s akin to finding a designer gadget at a garage sale price - a clear buy signal for those following Graham’s script.
Limitations of the Graham Number
While the Graham Number can act as your financial north star, it’s not without its quirks. It doesn’t attend the party where factors like market dynamics, technological disruptions, or the CEO’s charisma play out. It’s akin to judging the health of a tree solely by its trunk, ignoring the condition of its leaves and roots.
Related Financial Terms
- Price-to-Earnings (P/E) Ratio: Measurement of current share price relative to its per-share earnings.
- Book Value: Total value of a company if it were liquidated and debts settled.
- Earnings Per Share (EPS): Indicator of a company’s profitability on a per-share basis.
- Price-to-Book (P/B) Ratio: Comparison of market value with its book value.
Recommended Books for Further Studies
- “The Intelligent Investor” by Benjamin Graham: Dive deep into the philosophy of value investing, guided by the guru himself.
- “Security Analysis” by Benjamin Graham and David Dodd: Explore the foundational texts that shaped investment analysis.
Benjamin Graham’s number helps distill a complex market down to more palpable numbers, guiding investors towards potentially underpriced stocks. As you wield this potent financial tool, remember, it’s merely one slice of the investment pie, best served with a side of comprehensive analysis and a sprinkle of market instinct. Always worth a second look.
