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Stock Picks For The Week (Sept. 18 - 22, 2017) By First Metro Securities

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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!

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