How to Value Stocks

Stock Valuation Formula From Benjamin Graham

Benjamin Graham and the Power of Growth Stocks, Part 2 in a Series

 

“The intrinsic value of a company lies entirely in its future.”

–          Warren Buffett

Wall Street has relied on many formulas for determining whether the current price of a stock is high, low or right on target. But there are few, if any, strategies that are more effective than a little-known methodology espoused by the late Benjamin Graham in 1962, according to author Frederick Martin of Disciplined Growth Investors.

In the 1962 edition of his book “Securities Analysis,” Graham introduced a simple-yet-brilliant strategy for investing in growth stocks in Chapter 39. However, in subsequent editions of “Securities Analysis,” that chapter was inextricably omitted, so readers have been denied the opportunity to learn Graham’s growth stock strategy for the past half century.

Fortunately, that strategy was revived in 2011, when Martin reintroduced it in his book, “Benjamin Graham and the Power of Growth Stocks” (McGraw-Hill). Martin, the president and chief investment officer of Disciplined Growth Investors in Minneapolis, had read the 1962 edition of Graham’s book and has used the methodology with great success as the basis of his portfolio management methodology for nearly 40 years.

What makes the formula so effective? One of the great difficulties of effectively valuing stocks is that you must account for so many variables—earnings, revenue, growth rate, competitive environment, and long-term prospects, among others.  Graham’s formula helps solve that issue, according to Martin, by limiting the variables. “Benjamin Graham provided all stock market investors (both growth and value) with a critically important tool that freezes one of the key variables of the investment process to simplify the purchase decision,” explained Martin.

Here’s the formula:

Intrinsic Value = 8.5 + (2 x Earnings Growth) x Earnings per Share

For example, the value of a company with an earnings growth rate of 3% and earnings per share of $2 would be calculated like this:

8.5 + (2 x 3) = 14.5 x 2 = $28 intrinsic value

That stock would have a price-earnings ratio of 14.5.

A faster growing company—with a 10 percent growth rate and $2 of earnings per share—would look like this:

8.5 + (2 x 10) = $28.5 x 2 = $57

That stock would have a price-earnings ratio of 28.5. If that seems a little rich for your tastes, there’s a twist to the methodology that analysts sometimes overlook.

According to Martin, “in order to calculate today’s intrinsic value using Graham’s formula, one must estimate the company’s normalized current earnings per share and forecast the company’s earnings growth rate into the future.” An earnings growth rate based only on the past four quarters represents too small of a sample size to accurately calculate a company’s true value.

“One must adjust for where we are in the overall economic cycle and the company’s industry cycle, and where the company is in its investment cycle,” Martin explained.

Graham, in fact, had suggested that his formula was designed to be used based on “the average annual growth rate expected over the next seven to ten years.”

So if you expect a company’s growth rate to slow down in the years ahead—which is typical of most growth stocks—you need to insert a lower, more realistic long-term growth rate into the formula. For instance, that company with a 10 percent current growth rate might see its average slip to 7 percent over the next 7 to 10 years. In that case, the valuation formula should look like this:

8.5 + (2 x 7) = 22.5 x 2(EPS) = $45

The revised price earnings ratio of 22.5 is a little more down-to-earth.

Does that mean that that stock would be a “buy” at a 22.5 price-earnings ratio? Not necessarily, according to Martin.  Before he buys a stock, he wants to have a “margin of safety.” How do you assure a margin of safety? Well…that’s an entire chapter in his book. But, in short, it means buying the stock at a price that gives you some latitude against loss if the company’s long-term growth doesn’t meet your expectations.

The margin of safety is a concept Graham also endorsed, with this caveat, “Even with a margin [of safety] in the investor’s favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss—not that loss is impossible.”

But Graham’s methodology for valuing stocks is a good first step in a prudent investment process.