What Is the Graham Number?
The Graham number is the upper bound of the price range that a defensive investor should pay for the stock. According to the theory, any stock price below the Graham number is considered undervalued and thus worth investing in.
- The Graham number is a metric to determine the highest price that an investor should pay for a particular stock.
- It was developed by legendary value investor Benjamin Graham.
- The number is arrived at using a company's earnings and book value, both on a per-share basis.
- The Graham number is normalized by a factor of 22.5, to represent an 'ideal' P/E ratio of no more than 15x and a P/B of 1.5x.
The Formula for Graham Number
22.5 × (earnings per share) × (book value per share)
- Earnings per share (EPS) is calculated as a company's net profit divided by the number of outstanding shares of its common stock.
- Book value per share (BVPS) is the ratio of equity available to common shareholders divided by the number of outstanding shares. This figure represents the minimum value of a company's equity and measures the book value of a firm on a per-share basis.
Understanding the Graham Number
The Graham number is named after the "father of value investing," Benjamin Graham. It is used as a general test when trying to identify stocks that are currently selling for a good price. The 22.5 figure is included in the calculation to account for Graham's belief that the price-to-earnings (P/E) ratio should not be over 15x and the BVPS should not be over 1.5x (thus, 15 x 1.5 = 22.5).
The Graham number can thus be alternatively calculated as:
15 × 1.5 × (shares outstandingnet income) × (shares outstandingshareholders’ equity)
Essentially, this second method of calculation is equivalent to the first, wherein EPS = net income/shares outstanding, and book value is another term for shareholders’ equity.
According to Benjamin Graham, the current price should not be more than 1 1/2 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly higher multiplier of assets. As a rule of thumb, the product of the multiplier times the ratio of price to book value should not exceed 22.5.
Example of the Graham Number
For example, if the earning per share for a single share of company ABC is $1.50, the book value per share is $10, the Graham number would be 18.37. ((22.5*1.5*10)1/2= 18.37). Again, $18.37 is the maximum price an investor should pay for a share of ABC, according to Graham. If ABC is priced at $16, it is attractive; if priced at $19, it should be avoided.
Limitations of the Graham Number
The calculation for the Graham number does leave out many fundamental characteristics, which are considered to comprise a good investment, such as management quality, major shareholders, industry characteristics, and the competitive landscape.
With regard to stocks and equity instruments, fundamental analysis is a method of determining the value that focuses on key metrics and economic indicators, such as revenues, earnings, where an industry is in its cycle, return on equity (ROE), and profit margins.
Fundamental analysis relies on a company’s financial statements. One of the most famous and successful fundamental analysts, Warren Buffett—aka "the Oracle of Omaha"—is famous for successfully employing fundamental analysis. Warren Buffett was both a student and employee of Benjamin Graham. The fundamental method of security analysis is considered to be the opposite of technical analysis.
What Is a Good Graham's Number?
Graham's number will always present a maximum stock price given a company's EPS and BVPS. As a result, any stock price below that figure should signal a good buy for a value investor.
How Does the Graham Number Work in Value Investing?
The Graham number takes a company's per-share metrics and normalizes it based on a recommended upward limit for value investors of 15x P/E and 1.5x P/B.
Who Was Benjamin Graham?
Benjamin Graham is one of the founding fathers of value investing, and a financial guru to many famous value investors such as Warren Buffett. Graham's philosophy was to closely examine a company's financial statements to identify undervalued opportunities. His book, The Interpretation of Financial Statements is widely regarded as foundational for value investing.