Benjamin Graham's Misquoted Intrinsic Value Formula

There is a surprisingly common misconception that Graham recommended investing in stocks using the formula:

V = EPS x (8.5 + 2g), or
Value = Current (Normal) Earnings x (8.5 plus twice the expected annual growth rate)

A quick online search for "Benjamin Graham Formula" will bring up dozens of analysts, websites and stock screeners recommending stocks using this wrong formula. In fact, it is more popular than the actual 17 calculations given by Graham for stock selection, probably because it is easier to use.

What Graham Actually Wrote:

Graham was completely against any kind of Charting/Technical Analysis/Forecasting. He always analyzed stocks based on past performance and wrote entire chapters on stock selection. This formula is not mentioned anywhere in them.

He only mentions this formula to show how unrealistic the market's growth expectations are, when seen retrospectively.

A few paragraphs after mentioning this formula, he writes:

Warning: This material is supplied for illustrative purposes only, and because of the inescapable necessity in security analysis to project the future growth rate for most companies studied. Let the reader not be misled into thinking that such projections have any high degree of reliability or, conversely, that future prices can be counted on to behave accordingly as the prophecies are realized, surpassed, or disappointed.

There is even a footnote in the original 1973 edition of The Intelligent Investor (click on the image to see a scan) to clarify that this equation does really give any "true value."

This footnote is missing in more recent editions of the book (it's now in the "Endnotes" section which is possibly the cause of the confusion). But the warning is present in the new editions too.

The Irony:

The irony of this entire story is that the very formula with which Graham meant to show how unreliable market forecasts and earnings forecasts were, is the formula recommended the most today as the "Benjamin Graham Formula"!

There is perhaps good reason why Graham's protege and most famous student, Warren Buffett, said "beware of geeks bearing formulas."

More Information:

For a more detailed analysis of this issue, please see Understanding The Benjamin Graham Formula Correctly.

To assess 5000+ NYSE and NASDAQ stocks today against the 17 rules that Graham actually specified for stock selection, please see the Classic Graham Screener or Tutorial - Benjamin Graham and Serenity Stocks.

Comments

The problem here is selecting the expected growth rate. The problem with the future is that it has not happened yet. So you can be way off with selecting a growth rate to plug in. This is a big problem for privately held companies that are not publicly traded. How do you establish a stock value for the private investors. My current employer is employee owned. They have a formula for establishing the quarterly trade price. But the formula usually results in many more sales than purchases. So the company ends up buying back stock.

serenity's picture

Absolutely, Northewest Bob!

In his book, Graham uses this formula to replicate other forecasting methods, while retrospectively showing how stocks never behave according to any such forecasts.
As seen above, he gives multiple warnings to never use any such formula.

And amazingly, this is the most commonly recommended Benjamin Graham method today!
Yesterday, there was even an article by an analyst from a renowned investment website that Graham recommended using the PEG ratio.

To quote Graham again (since he has written it all):
"We can go further and assert that in an astonishingly large proportion of the trading in common stocks, those engaged therein don’t appear to know—in polite terms—one part of their anatomy from another. "

I've read the 1949 edition of The Intelligent Investor & am going through the 1951 Edition ( 3 rd) of Security analysis, I've not come across the said formula in the Intelligent investor & not in security analysis so far. What edition of those books were you referring to.
Thank You

serenity's picture

Dear BRMR,

The formula is present both in the last edition of The Intelligent Investor written by Graham in 1973, as well as the recently released edition that was updated with commentary by Jason Zweig.

A more comprehensive article about this formula, with more screenshots comparing the two editions, is available here:
Understanding The Benjamin Graham Formula Correctly

Regards,
Serenity Support

Thanks a lot for pointing this out. I read this chapter just yesterday, I ignored the endnote and misunderstood that this formula was the recommended method for deriving the intrinsic value. Wonder what losses I would have incurred had it not been for this article!!

serenity's picture

Glad to be of help, Rajiv!

For a more detailed analysis of this issue, please see Understanding The Benjamin Graham Formula Correctly.

Thank you.

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