Sunday, 15 April 2012

Value Investing - Benjamin Graham's Formula

Benjamin Graham's Formula   

In The Intelligent InvestorBenjamin Graham describes a formula he used to value stocks. He disregarded complicated calculations and kept his formula simple. In his words: 
"Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the evaluation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations."

His formula is as follows:

Intrinsic Value = EPS * (8.5 + 2* G)

EPS = Earnings per Share, G = Long Term EPS Growth Rate

This formula has little practical value to most value investors. A company with an expected growth rate of 10% in EPS could have a P/E (Price/Earnings) of 28.5 to be considered a buy. Most value investors would reject it. However, Graham also preached Margin of Safety. Therefore, taking this formula and allowing a 50% Margin of Safety you arrive at a P/E of 14.25 . Many value investors would take a hard look at a company with a 14.5 P/E growing earnings at 10% a year.

The formula is efficient and simplistic but has its limits:  the model doesn’t work for every stock. It should never be used in isolation. The investor must take into account many other factors such as current asset value, debt to equity ratio etc.

Comment: Warren Buffett thought Benjamin Graham was not at his best when he came up with the various formulae to value stocks.

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