How to find intrinsic value of stocks using Graham formula?
Valuation is one of the most important aspects while investigating any stock for investing. A good business might not be a good investment if you overpay for it. However, most valuation methods like DCF analysis, EPS valuation, dividend discount model etc requires little assumptions and calculations.
Luckily, there are also a few valuation methods available that are pretty simple to use in order to find the true value of a company.
In this post, we are going to discuss one such valuation method which is really straightforward and simple to use. And this valuation method is known as Graham formula. Here are the topics that we are going to discuss today:
- A brief introduction to Benjamin Graham
- How to find the intrinsic value of stocks using Graham formula?
- Pros and cons of graham formula.
- Real life example of valuing stocks from Indian stock market using graham formula.
- Closing thoughts.
Overall, this post is going to be really helpful for all the beginners who are stuck with the valuation of stocks and want to learn the easiest approach to find the true intrinsic value of companies. Therefore, make sure to read this post till the end.
Let’s get started.
1. A brief introduction to Benjamin Graham
Benjamin Graham was a British-born American investor and economist. He was a sincere value investor and often credited for popularizing the concept of value investing among the investing population. Graham was also:
- Referred to as “The father of value investing”.
- A professor at Columbia business school.
- Author of the best selling books ‘Security Analysis’ and ‘The Intelligent Investor’
- Mentor of legendary investor, Warren Buffett
Graham was a strict follower of value investing and preferred purchasing amazing businesses when they were trading at a significant discount.
In his book- Security analysis, Benjamin Graham mentioned his formula to pick stocks which become overly popular among stock market investors for valuing stocks since then.
2. How to find the intrinsic value of stocks using Graham formula?
The Original formula shared by Benjamin Graham to find the true value of a company was
V* = EPS x (8.5 + 2g)
- V* = Intrinsic value of the stock
- EPS = Trailing twelve-month earnings per share of the company
- 8.5 = PE of a stock at 0% growth rate
- g = Growth rate of the company for the next 7-10 years
Anyways, this formula was published in 1962 and was revised later to meet the expected rate of return as a lot concerning the market and economy has changed since Graham’s time to present. The revised Graham formula is:
During 1962 in the United States, the risk-free rate of return was 4.4% (this can also be considered as the minimum required rate of return). However, to adjust the formula to the present, we divide 4.4 by the current AAA corporate bond yield (Y) to make the formula legit.
Presently, the AAA corporate bonds are yielding close to 4.22% in the United States. (Source: YCharts). In order to make an apple to apple comparison, we’ll consider the bond yield for 1962 and current yield- both for the United States. Therefore, you can consider the value of Y equal to 4.22% currently, which may be subjected to change in the future.
Quick note: You can also use the corporate bond yield of India in 1962 and current yield to normalize the equation for valuing Indian stocks. In such case, the value 4.4. will be replaced by the Indian corporate bond yield in 1962 and Y will be the current corporate bond yield in India. Make sure to use the correct values.
Note: The Adjusted Graham formula for conservative investors.
Many conservative investors have even modified the Graham formula further to reach a defensive intrinsic value of the stocks.
For example, Graham originally used 8.5 as the PE of the company with zero growth. However, many investors use this zero growth PE between 7 to 9, depending on the industry they are investigating and their own approach.
Further, Graham used a growth multiple of ‘2’ in his original equation. However, many investors argue that during Graham’s time, there were not many companies with a high growth rate, such as technology stocks which may grow at 15-25% per annum. Here, if you multiply this growth rate with a factor of ‘2’, the calculated intrinsic value can be quite aggressive. And hence, many investors use a factor of 1 or 1.5 for the growth rate multiple in their calculations.
Overall, the adjusted formula of conservative investors turns out to be:
V* = EPS x (7 + g) * (4.4/Y)
3. Pros and cons of Graham formula.
The biggest pros of Graham’s formula is its ease and straightforwardness. You do not require any difficult input or complex calculations to find the intrinsic value of a company using the Graham formula. In a few easy calculation steps, this method can help the investors to define the upper range of their purchase price in any stock.
However, as no valuation method is perfect, there are also a few cons of Graham formula. For example, one of the important inputs of Graham formula is EPS. Anyways, EPS can be manipulated a little by the companies using the different loopholes in the accounting principles, and it such scenarios the calculated intrinsic value might be misleading.
Another problem with Graham formula is that like most valuation methods, this formula also completely ignores the qualitative characteristics of a company like Industry characteristics, management quality, competitive advantage (moat) etc while calculating the true value of stocks.
4. Real life example of valuing stocks from Indian stock market using graham formula.
Now that you understood the basics of how you can value stocks using graham formula, let us use this formula to perform a basic stock valuation of a real-life example from the Indian stock market.
Here, we are taking the case study of HERO MOTOCORP (NSE: HEROMOTOCO) to find its true intrinsic value using the Graham formula. For Hero Motocorp,
- EPS (TTM) = Rs 186.29
- Expected growth (for the next 5 years) = 9.89%
(Past 5-year EPS growth rate per annum (CAGR) of Hero motocorp is 14.14%. Taking 30% safety on this growth rate as it is a large cap, we can estimate a conservative expected future growth rate of 9.89% for next few years).
Now first, let us find the intrinsic value of Hero motocorp using the original Graham formula,
V* = EPS x (8.5 + 2g)
= 186.29 x (8.5 + 2*9.89) = Rs 5268. 28
Now, using the revised formula with conservative zero-growth PE of 7 and growth multiple of one, the intrinsic value of Hero motocorp turns out to be:
V* = EPS x (7 + g) x (4.4/4.22)
= 186.29 x ( 7 + 9.89) x (4.4/4.22) =3280.65
At the time of writing this post, hero motocorp stock is trading at a market price of Rs 2961.90 and PE (TTM) of 15.90. Therefore, by using Graham formula, we can consider this stock to be currently undervalued.
Disclaimer: The case study used above is just for educational purpose and should not be considered as a stock advisory. Please research the company carefully before investing. After all, no one cares more about your money than you do.
You can also use Trade Brains’ online GRAHAM CALCULATOR to perform your calculations fast.
5. Closing thoughts.
An important point worth mentioned here is the concept of margin of safety that Benjamin Graham repeatedly taught in his books.
In simple words, according to the concept of margin of safety, if the calculated intrinsic price of a company turns out to be Rs 100, always give your calculations a little safety and purchase the stock at a 15-25% below that calculated value, i.e. when the stock trades below Rs 75-85.
Overall, Graham formula is a fast, simple and straightforward method to find the intrinsic value of stocks. If you haven’t tried it yet, you should definitely use this valuation approach while performing the fundamental analysis of any stock.
Investing for Beginners
If you are new to investing, you can learn how to perform stock valuation and pick profitable shares for consistent returns in the Indian stock market with Trade Brains flagship course ‘How to pick winning stocks’. It is a self-paced online course with lifetime access so that you can learn on your own schedule. This course is currently available at a discount. Check out more here. Happy investing!!!
Additional credits: Vasanth (for data inputs in Graham Formula)
Hi, I am Kritesh (Tweet me here), an NSE Certified Equity Fundamental Analyst and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting