Graham Number

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

1. 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”.
2. 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.
3. 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)

Related Finance Terms

• Value Investing
• Benjamin Graham
• Earnings per Share (EPS)
• Book Value per Share (BVPS)
• Stock Valuation

Sources for More Information

• Investopedia
• Corporate Finance Institute
• The Motley Fool
• GuruFocus