Those of you grappling with perhaps the most difficult investing challenge of all, valuation, might be interested to know of a simple formula Benjamin Graham articulated in "The Intelligent Investor" for the valuation of growth stocks. In his words: “Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the evaluation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations.”
The initial formula as described by Graham was as follows: Intrinsic Value = EPS * (8.5 + 2g). In this case, g represents the expected annual growth “over the next seven to ten years”. 8.5x was therefore Graham’s effective base P/E for a no-growth company.
This formula however took no account of prevailing interest rates. He revised his formula in 1974 as follows: Intrinsic Value = EPS * (8.5 + 2g) * 4.4 / Y where Y was the current yield on 20 year AAA corporate bonds. The current yield on US AAA corporate bonds is 4.35%, as you can see on Yahoo Finance.
Is the Graham Formula Useful?
You can compare the fair value given by a two-stage discounted cash flows model with the fair value of Graham's Formula. The conclusion is that the formula broadly equates to the two-stage DCF value (with that set of assumptions at least!).
Watch Out For
Benjamin Graham however did provide a caveat to the use of this equation. Of companies with a below-par debt position, Graham wrote: "My advice to analysts would be to limit your appraisals to enterprises of investment quality, excluding from that category such as do not meet specific criteria of financial strength". In the book “Small Stocks, Big Profits”, Dr. Gerald Perritt summarised four quantitative caveats:
- The firm must not be excessively levered, i.e. it should not have debt to total asset ratios greater than 60% of total assets.
- The firm must have positive earnings (i.e. no losses)
- The share price must be below net working capital per share.
- The inverse PE (i.e E/P) should be greater than twice the AAA bond yield.
Arguably, however, this is confusing Graham's screening criteria with the valuation formula. The first two seems quite reasonable in any case. Of those criteria, the last two are the most severe and may be open to debate as they restrict use of the formula in most…