How To Value A Stock Using The Graham Formula | The Investing Engineer PH
first metro sec

Stock Picks for the week (Feb. 12-15, 2018) by First Metro Securities

Check out the Stock Picks for the week by First Metro Securities in this special report which you can find only here in PinoyInvestor. (Needs premium access.)

16

How To Value A Stock Using The Graham Formula

Valuating a stock price is based on intelligent assumptions. To find the intrinsic value of a stock, we have to make assumptions in the future based on past performance. It is in these assumptions that we find an ‘estimate’ of what the stock will be worth.

We can’t really predict what will happen in the future that is why valuation is not really a science; it’s an art.

In 1934, Benjamin Graham, one of Warren Buffett’s mentors, published his book entitled Security Analysis and that book contains one of his famous artwork in stock valuation; the Graham Formula.

V = EPS x (8.5+2g)

Where;

V = intrinsic value of the stock

EPS = earnings per share in the twelve trailing months period

g = growth rate of the stock for the next 7 years

Graham revised the formula later on to include a rate of return of 4.4% which is the risk free interest rate during his time. To adjust to the present, we divide a constant Y, which is today’s corporate bond rate with a AAA rating.

The final formula is this;

V = [EPS x (8.5+2g) x 4.4] / Y

Where;

Y = today’s corporate bond rate with a AAA rating

According to Graham, the constant number of 8.5 is the P/E ratio of a 0% growth company. Exactly how he got that number is not clearly explained. Depending on how conservative you are, you can adjust the value between 7 and 8.5 and as for the constant number of 2, to be less aggressive, you can adjust it to 1.5 or 1.

To apply this formula to the Philippine setting, I’ll use the Philippine government bond rates for a 20-yr period instead of the AAA corporate bond rates of the US.

Testing Graham’s Formula

Now let’s test the formula out to one of the SAM Stocks, Megaworld Corp. (MEG)

As of writing, let;

EPS  = 0.32 (TTM)

Y = 5.14

To compute for the growth rate, we get the 7-yr. CAGR (compounded annual growth rate). Here’s the EPS of MEG for the last 7 years.

7-yr. EPS:

2008 = 0.19

2009 = 0.18

2010 = 0.20

2011 = 0.32

2012 = 0.28

2013 = 0.31

2014 = 0.67

TTM = 0.32

The formula for CAGR is this;

CAGR = {[(present EPS/previous EPS)^(1/(period-1))] – 1} x 100

Applying the formula;

CAGR = {[(0.32/0.19)^(1/7)] – 1} x 100

CAGR = 7.73%

Now we apply the Graham Formula;

V = {0.32*[8.5 + 2*(7.73)]*4.4} / 5.14

V = 6.55 Php

The intrinsic value of MEG as per the Graham model is 6.55 Php. Applying a 25% margin of safety;

Buy below price = 6.55 – 0.25*(6.55)

Buy below price = 4.91 Php

We now conclude that MEG has an intrinsic value of 6.55 Php and we should buy the stock at a price below 4.91 Php as per the Graham model of valuation. As of this writing, MEG’s stock price is 4.83 Php.

Let’s try another SAM Stock, Universal Robina Corp. (URC). Let’s get the data first.

7-yr. EPS:

2008 = 0.20

2009 = 1.81

2010 = 3.75

2011 = 2.26

2012 = 3.70

2013 = 4.60

2014 = 5.30

TTM = 5.74

Y = 5.14

Computing for CAGR;

CAGR = {[(5.74/0.20)^(1/7)] – 1} x 100

CAGR = 61.54%

Using Graham’s formula;

V = {5.74*[8.5 + 2*(61.54)]*4.4} / 5.14

V = 646.49 Php

Applying a 25% margin of safety, we have 484.87 Php.

We now conclude that according to the Graham model of valuation, URC’s intrinsic value is 646.49 Php and we should buy the stock below the price of 484.87 Php. As of writing, URC’s stock price is 207.20 Php

For the last SAM stock, let’s try the Graham formula on Ayala Corp. (AC)

Here’s the data;

EPS (TTM) = 29.69

Y = 5.14

CAGR = 18.55%

Using the Graham formula;

V = {29.69*[8.5+(2*18.55)]*4.4}/5.14

V = 1,159.13 Php

Applying a 25% margin of safety, we have 869.35 Php.

So to conclude, the intrinsic value of AC according to the Graham model of valuation is 1,159.13 Php and a buy below price of 869.35 Php. As of writing, AC’s stock price is 776.50 Php.

Now what if I’m a conservative and not too aggressive type of investor? If that’s the case, we can tweak the formula a little. Let’s see what will be the valuations when I use a constant of 7.75 for the P/E ratio of a 0% growth company and 1.5 for g.

Here’s the new formula;

V = [EPS x (7.75+1.5g) x 4.4]/Y

Let’s now test the formula out on our SAM stocks.

MEG; V = {0.32*[7.75+(1.5*7.73)]*4.4} / 5.14 = 5.30 Php

URC; V = {5.74*[7.75 + (1.5*61.54)]*4.4} / 5.14 = 491.63 Php

AC; V = {29.69*[7.75+(1.5*18.55)]*4.4} / 5.14 = 904.30 Php

Final Thoughts

I believe the Graham Formula should note be used as an ultimate basis for stock valuation. Instead, it should only be used as a demonstration of how an assumed growth rate (g) can affect the computation of intrinsic value.

The outcome of the formula will depend on the variables that you will use so always choose your variables based on your investing strategies.

Happy investing!

Model Portfolios: Unloved, Value Play, Yield Seeker, Riding the Momentum (Feb. 14, 2018)

Looking for model portfolios to guide your stock picking decisions? Don't worry, we got you covered! Check out this special stock picks and model portfolio report today! (Needs premium access.)

  • Where can I find the value of the corporate bond rate with a AAA rating? Thanks.

  • Heston says:

    Hi,

    Good article, I’m still a newbie and would like to know where you get the 7 year eps of a company? Thanks

  • Joebel says:

    Hi Mark,Thank you for your post.is the “g”(eps growth rate) is calculated as a whole number not in percentage?appreciate you response.Thank you

  • tantan says:

    Hi Mark, Thanks for sharing your knowledge. As of this writing the current corporate bond rate with a AAA is 3.53. is that right?

  • Doms says:

    Hi,

    This is great! How does this approach fair with the intelligent investor formula as seen from the website below?

    http://www.netnethunter.com/my-ncav-investment-scorecard/

    • Hi Doms,

      I haven’t tried using NCAV yet in my valuations. I might consider that as well. The only disadvantage I see with NCAV approach is that you can’t use it on stocks in the financial sector.

      Here’s one resource about NCAV for additional reading.

      https://www.aaii.com/computerized-investing/article/benjamin-graham-s-net-current-asset-value-approach.pdf

      • Doms says:

        Hi,

        Last question. Not sure if you use COL financials but sometimes they have news letter there that provides fair value for certain stock picks. If we remove the 25% margin of safety from the equation. Do you think their computation of fair value is the same as benajmin’s computation?

        • Actually, my broker is COL. I’m not sure how do COL’s financial analysts valuates a stock, I guess they do many methods including DCF. I also think they use a lot of metrics and even corporate news affects how they make FV estimates. So I guess the values that you’ll get using Graham’s method will be very different from COL’s estimates.

          I think the buy below price of COL is similar to the margin of safety concept. I’m just not sure how many percent COL use in their equations. I view valuation as more of an art rather than science because in the end, no one really knows how a stock will perform.

  • Mooybien says:

    Hi Mark,

    Are all of these formulas included in your e-book?

    Thank you.

  • >