Graham's Intrinsic Value Formula

Graham did create a very useful and easy-to-use intrinsic value formula.

Graham's formula: You take a current earnings, apply a base P/E ratio, add a growth factor if there is a growth, and adjust according to current bond yield. The result is an intrinsic value that the stock can be expected to achieve in the real world if growth targets are met.

Formula: Intrinsic value = E x (2g + 8.5) x 4.4/Y

E = current annual earnings per share
g = annual earnings growth rate. (Graham would have suggested using a conservative number for growth.)
8.5 = base P/E ratio for a stock with no growth
Y = current interest rate, represented as the average rate on high-grade corporate bonds. (Note that lower bond rates make the intrinsic value higher, as future earnings streams are worth more in a lower interest rate environment.)

Take Hewlett Packard as an example. With current earnings (trailing 12 months) of $2.30 per share, a growth rate of 10%, and a corporate bond interest rate of 6%, the intrinsic value is

= $2.30 x [(2 x 10) + 8.5] x (4.4/6)
= $48.07 per share

This value almost exactly matches the price at the time that these calculations were made. That suggests little potential price appreciation in the stock - unless per share earnings growth accelerates or bond yields dip.

Acceleration in the business would increase the earnings growth rate, and share repurchases would increase the earnings per share. Both changes, especially taken together, would stimulate growth in intrinsic value.

You shouldn't go out and buy or sell stock based on this formula alone, of course, but it's a great "quick" test of a stock's price and true value.