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The stock market is a place where trends shift, and prices can rise and fall in minutes. In such a situation, investors often look for reliable metrics that can help them evaluate the intrinsic value of a stock. One such metric that stands out for its rational approach is the Graham Number. Named after renowned investor Benjamin Graham, it serves as a fundamental instrument for value investors searching for profitable ventures in the stock market.
What is Graham Number?
The Graham Number calculates the intrinsic value of a stock by considering the earnings per share or EPS and book value per share or BVPS of the company. The top limit of the price range that a defensive investor ought to pay for an investment is known as the Graham Number. The theory states that any stock value lower than the Graham Number is deemed inexpensive and, thus, a worthwhile investment.
Graham Number formula
To properly use the Graham Number, knowing its formula is essential. Graham Number is basically the square root of the fundamental value of the stock.
Fundamental value of stock = 22.5× (EPS) × (BVPS)
Graham Number = √22.5× (EPS) × (BVPS)
Where,
EPS = Net Income / Shares Outstanding
BVPS = Shareholder’s Equity / Shares Outstanding
Two basic considerations on the calculation are:
- The price-to-earnings ratio, denoted by the EPS multiple of 15, is the maximum value that may be achieved in any given scenario. If the company’s P&E ratio is greater than 15%, this calculation is not applicable.
- The price-to-book ratio is represented by the BVPS multiple of 1.5. There should be less than 1.5 as the ratio of P to B. If the company’s stock price exceeds the P&B ratio limitation, this stock valuation method cannot be utilised to determine the stock value.
Graham Number example
Let us look at an example to understand Graham Number stock.
Mr Sen wants to purchase the shares of XYZ Ltd and wants to use the Graham Number to see if it is worth it.
XYZ has made an earning of ₹ 50,00,000 for a year where the equity for the shareholders is ₹ 500,000, and the outstanding shares are ₹ 400,000.
EPS = 50,00,000 / 400,000 = 12.5
BVPS = 500,000/ 400,000 = 1.25
Fundamental value of stock = 22.5 * 12.5 * 1.25 = 351.5625
Graham Number = √351.5625 = 18.75
If the stock is traded at a value below 18.75, then Mr Sen should invest in the stock. Otherwise, it will be considered overvalued.
Advantages of Graham Number
Investors, especially value investors, can benefit from the Graham Number in a number of ways. The following are the main benefits of applying the Graham Number:
- Simplicity and accessibility: Due to its comparatively simple formula, the Graham Number is easily calculated by a broad spectrum of investors. Without the need for sophisticated financial models or specialised tools, investors can use the Graham Number to assess stocks by utilising easily accessible financial data, such as EPS and BVPS.
- Better assessment: The Graham Number method considers a company’s assets as well as its earnings. It offers a more thorough understanding of a company’s worth by taking into account both aspects. A corporation with substantial revenue but low book value, for instance, can be well-run but have few physical assets. On the other hand, a business that has a strong book value but low profitability can indicate that it has a lot of assets but isn’t making a lot of money. Investors can assess a company’s true worth by balancing these two factors, which can be done with the use of the Graham Number approach.
- Safety margin: Benjamin Graham popularised the margin of safety, one of the core ideas of value investing. This margin of safety is naturally built in by the Graham Number, which sets the maximum price an investor should pay for a stock while taking its earnings and physical assets into account. Putting money down below the Graham Number gives investors a safety net against any losses.
- Better screening: When searching for inexpensive stocks in a certain market or sector, investors might find great value in using the Graham Number as a screening tool. Investors can identify stocks that seem to offer potential value and prioritise their further study by comparing the market price of those equities to their Graham Number.
Graham Number: Limitations
Even though the Graham Number is a useful tool for stock market analysis, understanding its limitations is essential to making wise investment choices. The following are the main restrictions on the Graham Number:
- Sole focus on quantitative indicators: The Graham Number mainly uses quantitative indicators like book value per share and earnings per share. Qualitative aspects like competitive advantage, managerial calibre, market trends, and potential for future growth are not considered. Ignoring these qualitative factors could result in the omission of important details that affect a business’s long-term success.
- Static nature: Based on a company’s current earnings and book value, the Graham Number offers a quick overview of its underlying value. But businesses are dynamic, ever-changing entities. A firm’s intrinsic worth may change due to changes in the market, technical improvements, regulatory changes, or management strategy, rendering the Graham Number’s evaluation of the company out of date or lacking.
Graham Number stocks in India
A number of firms in the Indian stock market might fit the Graham Number model, which could present possibilities for value investors. These businesses usually have good book values, consistent profit growth, and fair pricing in relation to their inherent value. Potential
Graham Number stocks India might be well-known businesses in industries with solid fundamentals, such as consumer goods, utilities, and pharmaceuticals. In these areas, market prices may periodically diverge from intrinsic values, giving value-conscious investors the chance to find hidden treasures. According to the stock market report of 23rd April, MRF Ltd has the highest Graham Number at 61,065.6, followed by Shree Cements Ltd at 8,516.1 and Bosch Ltd at 8,134.2.
Conclusion
In the field of stock market analysis, the Graham Number is a classic indicator that is based on Benjamin Graham’s value investing theories. Investors looking for cheap alternatives with long-term growth potential might benefit greatly from it because of its simplicity, concentration on fundamentals, and emphasis on maintaining a margin of safety.
The Graham Number has limitations and should be used in conjunction with qualitative analysis and market factors, but its continued applicability highlights how crucial it is for navigating the complexity of stock valuation. An investor’s capacity to recognise potential investments and construct a strong portfolio in line with their financial objectives can be improved by comprehending and using the Graham Number efficiently.
FAQs
The Graham Number is the top limit of the price range that a defensive investor should pay for the stock.
The theory states that any stock price below the Graham Number is deemed inexpensive and, thus, a worthwhile investment.
The square root of 22.5 × (earnings per share) × (book value per share) can be used to express the formula. Two requirements must be satisfied in order to use this approach. P/E, or profit to earnings, should be less than 15. P/B, or price-to-book ratio, should also be less than 1.5.
For almost 50 years, the Graham Number has been widely used. It assists investors in selecting inexpensive equities to purchase. However, it is not a reliable tool for asset-light enterprises. In today’s environment, where businesses rely heavily on technology for all of their needs, big and small, this becomes extremely important.
Benjamin Graham, the renowned value investor, created it. The figure is calculated using the book value and earnings per share of a corporation.