Definition
The Graham Number is a figure derived from a formula developed by Benjamin Graham, a renowned investor and mentor to Warren Buffet. It is used to measure a company’s fundamental value by taking into account earnings per share and book value per share. It helps to identify the maximum price that a defensive investor should pay for a stock of a company, thus aiding in decision making in investments.
Phonetic
The phonetics for “Graham Number” is: /ˈɡreɪ.əm ˈnʌm.bər/
Key Takeaways
- The Graham Number is a figure that measures a company’s fundamental value by taking into account the company’s earnings per share and book value per share. It is named after the “father of value investing,” Benjamin Graham, who co-authored the widely acclaimed book, “The Intelligent Investor”.
- The Graham Number is calculated by the square root of “22.5 x earnings per share x book value per share.” The factor of 22.5 is a mixed figure that Graham determined as an appropriate measurement, being a compromise between the price-to-earnings ratio and the price-to-book ratio.
- It is typically used in the context of value investing as a quick and easy way to determine if a stock is under- or over-valued, relative to fundamental financial data. It can be a useful tool for comparing a company’s intrinsic value to its actual market price. However, it’s important to keep in mind that it should not be the only metric used when making investing decisions.
Importance
The Graham Number is a significant financial term used mainly in value investing, named after Benjamin Graham, known as “the father of value investing.” It is important because it serves as a simplified method to determine a company’s intrinsic value, essentially estimating the maximum price a conservative investor should pay for a given stock. It takes into consideration earnings per share (EPS) and book value per share (BVPS), underlining the fundamental financial health and potential growth of a business. By using the Graham Number, investors can more objectively evaluate if a stock is undervalued, fairly priced, or overvalued, increasing their chances of making a profitable investment.
Explanation
In the realm of financial analysis, the Graham Number serves a pivotal role, as it represents a conservative estimate of a company’s actual intrinsic value. It essentially points out the maximum price an investor should pay for a given stock, based on a company’s earnings per share (EPS) and book value per share (BVPS). Attributed to the philosophy of Benjamin Graham, the father of value investing, the calculation was designed to create safety nets for investors against potential pitfalls in value misjudgments. By relying on the Graham Number, investors safeguard themselves from paying markedly over the true value of a stock. It is an effort to bridge the gap between a business’s market price and its real worth. This number helps in making investments less prone to risks involved in market pricing anomalies and assists the user in making a more informed decision about a value-based investment. It’s a mechanism that encourages disciplined investing, in order to ward off irrational exuberance in purchasing overly expensive stocks. In essence, the Graham Number functions as an indicator to keep one’s investment decisions grounded in rationality and observable financial metrics.
Examples
The Graham Number is a figure that measures a stock’s fundamental value by taking into account the company’s earnings per share and book value per share. This concept was developed by Benjamin Graham, the “father of value investing.”Here are three real-world examples using the Graham Number:1. Company A: This company has an earnings per share of $4 and a book value per share of $20. The Graham Number would be calculated as square root of (22.5 * $4 * $20) = $30. This suggests according to Graham’s criteria, the fair value for the company’s stock is $30 per share.2. Company B: This company has an earnings per share of $2 and a book value per share of $10. The Graham Number would be calculated as square root of (22.5 * $2 * $10) = $15. This suggests that, according to Graham’s criteria this company’s stock should be trading around $15 per share, if it’s fundamentally sound.3. Company C: This company has an earnings per share of $10 and a book value per share of $50. The Graham Number would be calculated as square root of (22.5 * $10 * $50) = $75. So, according to Graham’s rule, the fair value per share of this company’s stock is $75 if the fundamentals are good.In each of the examples above, the Graham Number is used as a benchmark to assess whether the company’s stock is overvalued or undervalued. If the current stock price is higher than the Graham Number, the stock is considered overvalued. If the current stock price is lower than the Graham Number, then the stock is considered undervalued.
Frequently Asked Questions(FAQ)
What is the Graham Number?
The Graham Number is a figure used in the world of finance and investing. It’s named after Benjamin Graham, the father of value investing. This number is essentially an estimate of the maximum value that a stock should have in a perfect market scenario.
How is the Graham Number calculated?
The Graham Number is calculated using the formula: √(22.5 x Earnings per Share x Book Value per Share). The multiplier 22.5 is a result of Graham’s belief that the price to earnings ratio (P/E) should not be above 15 and the price to book ratio (P/B) should not be above 1.5 for a stock to be a safe investment.
Why is the Graham Number important for investors?
The Graham Number is crucial for investors as it offers a simplified method to identify potentially undervalued stocks. If the current market price of a stock is less than the Graham Number, the stock can be considered undervalued.
Where can I find the data to calculate the Graham Number?
The necessary data to calculate the Graham Number, which includes Earnings per Share (EPS) and Book Value per Share (BVPS), can typically be found in a company’s annual report or on a good financial news website.
Is the Graham Number the sole determinant of whether to invest in a stock or not?
No, the Graham Number should only be used as an initial filter in the investment decision-making process. Other factors, such as a company’s cash flow, debt levels, market conditions, competitive landscape, and growth prospects, should also be considered.
Are there limitations to using the Graham Number?
Yes, there are limitations. The Graham Number is more applicable to certain companies over others. It tends to be most useful for fundamentally strong companies and those that have steady earnings and growth, rather than companies in volatile markets or with unpredictable earnings. Additionally, the calculation relies on historical data and does not account for future growth or changes in company circumstances.
Can I use the Graham Number for all types of companies?
No, the Graham Number is not applicable to all types of companies. It serves best for capital-intensive companies. Thus, in sectors like technology where assets are mostly intangible, the Graham Number might not give meaningful insights.
Related Finance Terms
- Value Investing
- Benjamin Graham
- Earnings per Share (EPS)
- Book Value per Share (BVPS)
- Stock Valuation
Sources for More Information
