If stock valuation is an art, then many would herald Benjamin Graham as the Leonardo Da Vinci of his time. Valuing assets was something which was a craft only reserved for those blessed with the knowledge, patience, and aptitude to feast on numbers, statements, and information which would bring a tear to many a glass eye. With underpriced stocks and the Graham formula, luckily for us, this does not have to be the case.

Underpriced Stocks & The Graham Formula

Graham’s formula was a simple method which was based on a number of variables. The purpose of the calculations was to identify stocks trading at worthy valuations. It must be made clear that the Graham Formula was not devised in order to absolutely value a stock but to arrive at an estimate of the value of that stock.

The formula itself was simple in how it was initially devised:

V* = EPS x (8.5 + 2g)

V* = Intrinsic value

EPS = Trailing twelve months earnings/share

8.5 = P/E ratio of a stock with 0% growth

g = growth rate for the next seven to ten years

As you can see from the formula above, it was considerably uncomplicated and merely based upon the most logical information pertaining to known stock performance and expected performance. The slight adjustment made by Graham incorporated a rate of return. The purpose behind the number 4.4 is that it represented the minimum required rate of return.

V* = {EPS x (8.5 + 2g) x 4.4} / Y

Y: the current yield on 20 year AAA corporate bonds.

V* = Intrinsic value

EPS = Trailing twelve months earnings/share

8.5 = P/E base for a no-growth company

g = Expected long term earnings growth rate

4.4 = Average yield of high-grade corporate bonds in 1962, when the formula was introduced

The modification was very minimal. In 1962, Graham published his works. Around the time this revision was made, the risk-free interest rate was at 4.4%. Using this formula in today’s terms requires dividing the number by the AAA corporate bond rate of today.

The Graham Formula, Underpriced Stocks and Modern Times

When considering things such as intrinsic value, we need to take into account factors which work against it. Intrinsic value should never be calculated over a 12 month period. Many who use the Graham Formula tend to adjust the EPS to a normalized number. By taking out any earnings out of the ordinary (either side) over a 10 year period, for example, this will avoid any tricky conclusions.

EPS is commonly known to be considerably prone to manipulation in the modern age. Normalizing EPS also gives us an advantage when we consider that earnings will never be intently understated by a company’s management. Projected EPS is also not advised as can depict a level of growth which will typically be grossly overestimated. In this case, Graham’s formula is criticized by some for its simplicity and the requirement to adjust growth in order to make it compatible with overall valuation in today’s terms.

In Conclusion

The purpose of Benjamin Graham’s formula was to devise a way which would calculate growth stock as accurately as possible. It is, still to this day, something which is lauded by many traders and investment professionals.

The key to using the formula in this day and age is to remember the contextual factors which were not around in his time. As such, adjusting the original formula is necessary in order for the formula to be applied to other industries in practice. Valuation is used in order to find a range of numbers (there is no absolute range).

About the writer: Jeremy Biberdorf is the owner & founder of the popular investing blog modestmoney.com.  Check out his site for latest investing news and tips

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