Monday, 6 February 2012

Graham's Valuation Formula

Investing is a multidimensional activity.

To cope with this complexity, investors have resorted to increasingly powerful computers that purport to capture the inter-relatedness of many variables.  But this approach tends to lose the most valuable input of all:  human intuition.

A far better solution for the investment process would be to "freeze" some variables so that analyses could focus on a reasonable number of factors.

Benjamin Graham's valuation formula provided all stock market investors with a critically important tool that freezes one of the key variables of the investment process to simplify the purchase decision.  By using Graham's formula, investors are freed to consider other important factors when evaluating a public company.

To calculate intrinsic value, multiply the earnings growth rate by 2 and add 8.5 to the total, then multiply that by the current earnings per share.

[8.5 + (2 x growth) ] x EPS = Intrinsic Value per share

1.  A no-growth company.   The company would have a P/E ratio of 8.5 (and an earnings yield of 12%), which is a fairly typical P/E for a mature company.

2.  An average-growing company.  Most analysts use a P/E range of 15 to 20 times earnings for the S&P 500.  This would translate into the average growth stock in the S&P 500 growing between the ranges of 3.25% to 5.75% (mean 4.5%).

3.  A faster-growing company.  A faster-growing stock growing at 10% will have a P/E ratio of 28.5.  This is fairly typical for the faster-growing companies in the S&P 500.

Two flaws in the valuation models.  All valuation models have flaws.

1.  Models such as Graham's value a company based solely on its earnings.  This leaves out the possible positive effects of non-operating assets or negative effects of non-operating liabilities..  That's why investors need to look beyond earnings and examine company balance sheets prior to purchase to look for non-operating assets and liabilities.

2.  A second flaw has to do with the potential competition from high interest rates.  Should the P/E ratio of stocks be immune to high interest rates?  Of course not.  Graham himself addressed this issue when he suggested that P/E ratios should be adjusted downward if long-term interest rates on AAA corporate bonds
exceeded 4.4%.  The revised Graham formula factors in the current yield to maturity on AAA corporate bonds in the calculation of a company's intrinsic value:

Intrinsic value per share = EPS x (8.5 + 2g) x 4.4 / y

g = growth rate
y = yield on AAA corporate bonds

If the yields on AAA corporate bonds were to remain at 4.4%, then the original Graham model would remain intact.

If the yields on AAA corporate bonds increased to 6.6%, the P/E ratios would be reduced by 1/3 (4.4/6.6 = 2/3).

If the yields on AAA corporate bonds increased to 8.8%, the P/E ratios would be cut by 1/2.  Thus, the future value of all companies would be reduced by 50%, all things being equal.

For those who want to use Graham's amended model, some caution is warranted.  The model requires that the user forecast interest rates well into the future.  For an investor to rely on recent interest rates as an input to the model could be misleading.

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