Using The Graham Number Correctly

One of the most popular Benjamin Graham methods these days is the Graham Number, which Graham actually did recommend.

Unlike the much touted Benjamin Graham Formula that he actually warned against, Graham actually did recommend the Graham Number.

But again, there is a big difference between how this calculation was recommended and how it is being used today.

Advanced Graham Screener

Derivation

The number itself is simple enough, and can be derived from rule [6] and [7] of Graham's rules for Defensive stocks.

1. Not less than $100 million of annual sales.
2-A. Current assets should be at least twice current liabilities.
2-B. Long-term debt should not exceed the net current assets.
3. Some earnings for the common stock in each of the past 10 years.
4. Uninterrupted [dividend] payments for at least the past 20 years.
5. A minimum increase of at least one-third in per-share earnings in the past 10 years.
6. Current price should not be more than 15 times average earnings.
7. Current price should not be more than 1½ times the book value.
As a rule of thumb, we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5.

Chapter 14: Stock Selection for the Defensive Investor, The Intelligent Investor

Criterion #1 works out to $500 million today based on the increase in CPI / Inflation.

The optimum price for a Defensive quality stock can easily be derived from the last three lines and this price is known as the Graham Number.

Graham Number = Square Root of (15 x 1.5 x EPS x BVPS)

Graham Number = Square Root of (22.5 x EPS x BVPS)

Versatility

The Graham Number is designed to quantitatively assess any stock, regardless of sector or industry.

For example, public utility companies that are typically low on earnings will need higher asset figures to be acceptable. Similarly, service sector companies that are typically low on assets will need higher earnings figures to be acceptable.

Misuses

The biggest concern today is that the Graham Number is now used in isolation almost everywhere, while the five other supporting criteria for defensive stock selection are completely ignored.

An online search for Graham Number will bring up dozens of stock screeners and analyst reports recommending stocks based on the Graham Number alone.

Another cause for concern is that Graham Numbers are now rarely calculated using the average earnings of the past three years as was required, even though Graham gave detailed explanations of how easy it was to manipulate a single year's earnings figure and why such averaging was essential.

Complete Procedure

The complete stock selection procedure recommended by Graham is far more elaborate.

1. Defensive

First a stock is checked against all seven criteria for Defensive investment above.

2. Enterprising

If the stock fails to meet any one of the above criteria, it is then checked against the five criteria for Enterprising investment (below).

[For issues selling at earnings "multipliers under 10"]

1-A. Current assets at least 1½ times current liabilities.
1-B. Debt not more than 110% of net current assets.
2. Earnings stability: No deficit in the last five years covered in the Stock Guide.
3. Dividend record: Some current dividend.
4. Earnings growth: Last year's earnings more than those of 1966.
5. Price: Less than 120% net tangible assets.

Chapter 15: Stock Selection for the Enterprising Investor, The Intelligent Investor

Criterion #4 corresponds approximately to using the earnings figure of four years ago.

This second set of criteria gives us an optimum price for a stock meeting the above conditions (an Enterprising stock) as — the lower of 120% net tangible assets (book value), or 10 times Trailing EPS.

This Intrinsic Value formula is quite different from the Graham Number but is equally, if not more, valuable today.

3. NCAV / Net-Net

If a stock meets neither of the above groups of checks, it is finally checked against the last two criteria for investment as an Net Current Asset Value (NCAV / Net-Net) or bargain stock (below).

Bargain Issues, or Net-Current-Asset Stocks
...price less than the applicable net current assets alone - after deducting all prior claims, and counting as zero the fixed and other assets.
...eliminated those which had reported net losses in the last 12-month period.

Chapter 15: Stock Selection for the Enterprising Investor, The Intelligent Investor

This last set of criteria, for a stock that meets neither of the first two sets of criteria, gives us an NCAV stock. This is a stock selling for less than the value of its cash worth alone, and with positive earnings (no losses) in the last one year.

Contemporary Relevance

Graham also included all the necessary information required to modernize his framework for changing interest rates, as well as varying rates of inflation.

For a complete understanding of stocks and investing, a reading of The Intelligent Investor by Benjamin Graham is highly recommended. This is the book that Warren Buffett himself describes — in his 1986 preface to it — as "by far the best book about investing ever written".

To Conclude

Graham's various sets of criteria are a fine balance of checks. There's no point if a stock meets just some of the criteria in a group and doesn't meet others. For example, it's easy for a stock to show a great asset number while having lots of debt.

In the end, choosing stocks that completely meet one of the latter two groups of Graham criteria is a far better approach, than investing in stocks that incompletely meet the defensive criteria.

But just using the Graham Number — which covers only two of the seven Defensive criteria — is not only excessively simplistic, but also potentially dangerous.

To assess 72,000+ global stocks today against all the above seventeen Graham rules, including the Graham Number, please see the Advanced Graham Screener.

Advanced Graham Screener

Customized Value Investing

Comments

HI there. Thanks for all the information your provide in your site. I have a question. I have an investor account in Australia´s stock exchange.
I wonder if Graham methods are valid as-is in this (or any other) stock exchange. Of course, his philosophy and ideas will stand in any country, but my question is if the specific mathematics would work the same or will need some adjustment.
Regards, Carlos

Hello Carlos,

The only one of Graham's criteria that seems region-specific is #5 of the defensive criteria - a minimum increase of one third in per share earnings over the past 10 years.

The rate of inflation in the United States when these criteria were published was about 5% annually. If the rate of inflation and the market cycle in Australia over the last 10 years was significantly different from the late 60s and early 70s in the United States, this criteria may need some slight adjustment.

The other Defensive, Enterprising and NCAV criteria should not require any adjustment if applied in USD.

Number 4 above says:
4. Uninterrupted payments for at least the past 20 years.

Does this mean dividends for the past 20 years? What is payments referring to?

Thanks!

#4 refers to uninterrupted dividend payments for at least the past 20 years.

Thank you!

Hi there, Just wanted to send you a note of approval as I find your website quite informative. I am working through The Intelligent Investor at the moment and am writing chapter summaries as I do so. Your website has been a great resource throughout this process. Thanks!

There are going to be some enhancements this quarter to Serenity's final analysis of stocks.
Do keep checking in.

can you use the Graham original formula for private company with $15M annual revenue, $50M enterprise value?

Hello SK,

Yes, you can. But you would need to use Book Value instead of Enterprise Value, as well as the 6 other supporting qualitative criteria.

Thank you for your comment!

Graham Resources