Stock valuation is as old as the financial markets and there are infinite ways that we can go about valuing equity in a company. In this article, we will explore a formula for stock valuation by Benjamin Graham, the father of value investing.
In his 1962 edition of Security Analysis, value investor Benjamin Graham described a formula. The formula is simple, seriously simple. Graham also recommended that people not take it too seriously, but to instead use it for exploratory purposes (more on that later). Let’s take a look at the revised Graham formula (Graham revised it for his 1974 edition of The Intelligent Investor).
At Affluenty we use this formula and provide you the value of every US stock using it (with the exception of negative EPS companies as they don’t play too well). We also have some tweaks that help make this a little better for modern day stock valuation, we’ll cover these shortly.
Let’s jump into the formula a little. ‘EPS’ is the earnings per share over the last twelve months. You can typically find this on financial sites under EPS (ttm) and we list it in our information for each stock.
The static value 8.5 is a P/E ratio for a company with no-growth, and g is the reasonably expected growth rate. This is where things get a little tricky, growth rates. At Affluenty, we trust the analysts for the most part. I say for the most part, because some companies might have ten-year growth rates listed at 50%, and it is simply foolish to assume any equity can grow at 50% per year for a decade. Sure, it has happened, but better to under assume and be shocked than to value things with astronomical growth assumptions. In those cases, we will eek the growth rate down a little.
Next up, 4.4. This was the average yield for high grade corporate bonds in 1962 when Benjamin Graham introduced the formula. We still use the 4.4 in our model at the time of writing.
Finally, Y. Y is the current yield on 20-year AAA rated corporate bonds. We update this occasionally. A quick Google search can get this rate for you, so there’s not much in the way of math there.
Microsoft Stock Valuation with Graham Formula
Alright, let’s take a look at a few examples of how we can use this formula in stock valuation with Microsoft (MSFT).
Step One, gather information. Microsoft’s EPS over the last twelve months is $2.11. If we look at what the analysts expect the growth to be, we get 13.68%, it’s pretty specific, but also reasonable for a company in Microsoft’s position. Again, be as reasonable as possible. Microsoft has many prospects ahead of them so 13% wouldn’t be outrageous, but if you do want to be more conservative, drop it down a little.
The final piece of information we need is the 20-year AAA bond rate. The St Louis Fed has a chart that covers that and gives us 4.61% at the time of writing.
Plugging in the numbers we get:
V = (2.11 * (8.5 + (2 * 13.68)) * 4.4) / 4.61
V = (2.11 * (8.5 + 27.36) * 4.4) / 4.61
V = (2.11 * 35.86 * 4.4) / 4.61
V = (332.92) / 4.61
V = 72.22
So, in this scenario, with these particular constraints the Graham Formula values Microsoft at $72.22. At the time of writing, Microsoft is trading at roughly $107 per share, so we would consider that overvalued. If we were strictly basing our investment decisions on the Graham Formula, Microsoft would not be a buy.
And Another… Generac Holdings
We can’t leave this article at a “no buy,” can we? Let’s try Generac Holdings (GNRC). I kind of cheated in finding this one, it was atop a list of Affluenty stocks that have a Piotroski score of 9 and are undervalued per the Graham Formula.
Generac has an EPS of $2.56 and growth is forecast at 8.5%. I’m sure we can all agree that 8.5% does not seem unreasonable, no matter the company.
V = (2.56 * (8.5 + (2 * 8.5)) * 4.4) / 4.61
V = (2.56 * (8.5 + 17) * 4.4) / 4.61
V = (2.56 * 25.5 * 4.4) / 4.61
V = 287.23 / 4.61
V = 62.31
$62.31 is our answer, and a quick check of the price at the time of writing ($54.74) shows that we have a margin of safety of 13.8%. We’d ideally look for around 25%, but simply finding a stock that is “undervalued” is a good starting point.
Hopefully this article covered stock valuation with the Graham Formula well. If you do have any questions, we’re all ears and you can contact us via our site Affluenty.com.