The Graham Number
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Many investors today will look to Warren Buffett as a mentor, watching his investing movements for clues on where to put their cash.
But where did Buffett look?
His mentor and widely considered Godfather of value investing was Benjamin Graham.
Benjamin Graham liked to focus on value stocks, in particular stocks that were trading below their net asset value. This is what he liked to call his margin of safety, his theory was - If the stock is trading below its net asset value and the company is worth less than its assets, this is effectively buying money for less than it is worth.
The Graham Number
The Graham number came about as a way of calculating the fair value of a stock. If the current price was under the calculated Graham number, then the stock was cheap and could be brought as a value investment. However, if the stock was trading above the Graham number then the stock was expensive and should be sold.
Graham believed that any stock should not be trading at a P/E greater than 15 and P/B value of more than 1.5. If the P/B ratio was greater than 1.5 then the assets of the company are selling at a premium to their actual value.
Graham Number = Square Root of (22.5 x Book Value Per Share x Earnings Per Share)
The 22.5 signifies Graham's belief that the P/E ratio should not be greater than 15 and the P/B no greater than 1.5 (15*1.5=22.5).
This ratio however does leave out many fundamental factors and could be unsuitable for many large and medium cap stocks. Although as a starting point for screening value possibilities it is a good place to start.
As an example of how the ratio works let’s take a look at Sherwin-Williams (NYSE: SHW)
Currently trading on a P/E ratio of 30 and a P/B ratio of 10 Sherwin-Williams does not match the required profile for the Graham number however this example does show how it work. With both the required ratios being above the upper limits set by Graham, the resulting Graham number is significantly less due to the resizing that occurs during the calculation. The result is a number that is significantly below the current price, making Sherwin-Williams look like a very unattractive value investment.
Chubb (NYSE: CB)
Widely speculated as Berkshire’s next acquisition, Chubb is my next example of a prospective value investment - according to Benjamin Graham. Trading at a P/B of approximately 1.3, Chubb is not cheap in a book value perspective; however the ratio is below the 1.5 level. The company is also trading on a low P/E of 11.2, once again below Graham’s limit of 15. These numbers result in a Graham value of $97.4 per share, approximately 26% away from the current share price.
Barrick (NYSE: ABX)
Gold miners have not been strong performers recently; however do they now look like worthwhile value investments. Barrick Gold is my candidate for analysis and it is trading at a premium to its book value per share. Barrick’s P/B ratio is 1.3 and the company is also trading on a low P/E multiple of 10. Both numbers are below Graham’s upper limit and result in a Graham value of $44.5 per share; A prospective upside of 32% from the current price. With this much upside Gold miners in my opinion are now starting to look attractive!
Xerox (NYSE: XRX)
A company that fits Graham’s requirements perfectly is Xerox. Currently trading below book value, you can buy $1 of Xerox’s assets for only 80c in this market. As a result Xerox presents possibly the best prospective upside. Xerox is currently trading on a P/E of 7.8, about half of the upper limit Graham has set for his calculation and it shows in the final ratio. The Graham value works out at $14.1, a prospective upside of 99%!
National Oilwell Varco (NYSE: NOV)
Finally another one of Buffetts favorites. National Oilwell Varco, Inc. the company is trading on a P/E of 12 and a P/B of just under the upper limit of 1.48. However this produces a Graham number of $76.1. National Oilwell has one of the lowest prospective upsides in the group at only 11%.
In summary, the Graham number can be a helpful tool for identifying prospective stocks, but can be unreliable and should not be used as the only analysis for investment.
RupertHargreav has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend National Oilwell Varco and Sherwin-Williams. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!