Monday, 6 February 2012

The Intrinsic Value Formula of Benjamin Graham

Intrinsic Value = E (2r + 8.5 ) x 4.4 / Y

E = Earnings
r =  Expected Earnings Growth rate
Y = Current yield on AAA corporate bonds.
8.5 = Graham believed this to be the correct P/E multiple for a company with no growth.

Therefore, Intrinsic Value will rise proportionately to

  • rising earnings, 
  • rising earnings growth rate and 
  • falling yields of AAA corporate bonds.
P/E ratios have risen in recent years, perhaps making 15 to 20 a more appropriate number for a company with no growth, but a conservative investor will continue to use a low multiplier.

Before accepting this formula too enthusiastically, you might reflect on Warren Buffett's response when asked about it.  "I never use formulas like that.  I never thought Ben was at his best when he worked with formulas either," he said with a chuckle.

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