Benjamin Graham Intrinsic Value Formula

A Look At How the Father of Value Investing Calculated the Intrinsic Value of an Ordinary Share of Common Stock

Benjamin Graham, the rich investor, professor, and mentor to Warren Buffett, once proposed a quick back-of-the-envelope intrinsic value formula for investors to determine if their stocks were at least somewhat rationally priced.  He encouraged investors to only buy shares that passed the test and, if the market fell substantially as it is prone to do from time to time, to sit back, collect the dividends from their share of the profits, and ignore the stock price, instead acting just as you would if you owned a neighborhood pharmacy or a local hotel.

Those who follow finance know that Graham is perhaps most famous for his margin of safety concept, his allegory of Mr. Market, and the value investing strategies he used at his hedge fund, Graham Newman Corporation.

The Benjamin Graham Intrinsic Value Formula Is Incomplete But Still Useful

Benjamin Graham’s intrinsic value formula isn’t perfect.  There are several flaws in the model but for the average person who wants to try and put together a diversified portfolio of high quality blue chip stocks that will grow over time without major wipeout risk, it does have utility.

[mainbodyad]What are the shortfalls?  It doesn’t account for capital intensity, for one.  That is important.  An illustration may help you understand why I’m adamant about that belief.

Imagine that Jane and John each own a business that earns $1,000,000 per year in profit.  Jane owns an advertising agency and only has to reinvest $100,000 in capital expenditures to maintain her business, upgrading phone lines, putting in new computers, installing new furniture, and raising employee salaries.  John owns a construction equipment company that requires him to reinvest $700,000 of his earnings to grow, all of which sits in his lot rusting until it is sold.  Even though both earn a taxable profit of $1,000,000 per year, Jane has $900,000 in cash that can be spent, reinvested, or given to charity.  John only has $300,000.  Same profits, yet Jane has 3x as much cash earnings, or “owner earnings”.  You’d be foolish to think that John’s business was a bargain even if it were offered at a 40% discount to Jane’s business.

Likewise, the Benjamin Graham intrinsic value formula doesn’t quite catch risks that require wise human judgment.  A horse and buggy manufacturer would have appeared incredibly cheap on an intrinsic value basis but anyone who understood that people would switch to automobiles would have avoided owning the stock because the current earnings were doomed to collapse unless the business model changed.  You cannot just rely on the model or formula without thinking about the implications behind the figures.  The Benjamin Graham intrinsic value formula wouldn’t have caught the fatal error committed by Lehman Bros. when it borrowed short-term money to finance long-term assets, leading to its bankruptcy despite a multi-billion dollar net worth.

But it’s still useful in serving as a safety check to help you avoid using stocks as a lottery ticket and overpaying for businesses.  The biggest challenge you will have will be reigning in your optimism and avoiding overestimating future growth rates in earnings per share.  Earnings do fall from time to time.  That is the world.  You need to accept that and build it in to your valuation.

How to Calculate the Benjamin Graham Intrinsic Value Formula

Benjamin Graham argued that a “fair” price for a stock, or its intrinsic value, could be calculated as follows:

IV = EPS x (8.5 + 2g)

IV = Intrinsic Value
EPS = Diluted Earnings Per Share
8.5 = Fair Price to Earnings Ratio for No Growth Company
(This implies a 11.76% earnings yield)
G = Conservatively estimated growth in EPS for the next 7 to 10 years

The formula needs to be modified, though, because all intrinsic value calculations and formulas are based upon the opportunity cost relative to the risk-free interest rate.  Graham based his figures upon the 1962 bond rates, which aren’t the same as today’s bond rates.  So we can adjust Ben Graham’s formula as follows:

IV = EPS x (8.5 +2g) x 4.4
Y

IV = Intrinsic Value
EPS = Diluted Earnings Per Share
8.5 = Fair Price to Earnings Ratio for No Growth Company
(This implies a 11.76% earnings yield)
G = Conservatively estimated growth in EPS for the next 7 to 10 years
4.4 = The average yield for high grade corporate bonds in 1962 when the model was introduced
Y = The Current Yield on AAA Rated Corporate Bonds

Looking at a Major Blue Chip Stock Using Ben Graham’s Formula

I wrote about Wal-Mart Stores, Inc., a few days ago in my essay on earnings yields of stocks versus yields of Treasury bonds.  Since it is fresh on many of your minds, let’s go back to it and apply Ben Graham’s formula.

Right now, the trailing twelve months earnings per share for Wal-Mart is $4.58.  If the company continues to buy back its own shares and grows its earnings at least with inflation, a 5% growth rate seems reasonable for the biggest retailer on the planet.  The current AAA bond yields are around 5.54%.  Plugging this into the formula, we get:

Step One:
IV = $4.58 x (8.5 +2*5) x 4.4
5.54

Step Two:
IV = $4.58 x (8.5 + 10) x 4.4
5.54

Step Three:
IV = $4.58 x (18.5) x 4.4
5.54

Step Four:
IV = $4.58 x 18.5 x 4.4
5.54

Step Five:
IV = 372.812
5.54

Step Six:
IV = $67.29 per share

Graham’s formula would indicate that a fair price, or the intrinsic value, of Wal-Mart’s stock is around $67.29 per share.  If you knew there was significant share dilution from stock options or convertible instruments, you’d adjust that figure appropriately.  If you expected interest rates to skyrocket, you’d lower the intrinsic value per share rate to compensate since your opportunity cost would rise.

Benjamin Graham’s Relative Intrinsic Value Formula

From here, you could calculate something called the relative intrinsic value of the stock.

RIV = IV ÷ Current Share Price

In the case of Wal-Mart, the stock trades for $53.63 so we would use that as the current share price.

RIV = $67.29 ÷ $53.63

RIV = 1.2547

In Graham’s world, anything over 1.00 is considered undervalued; the higher, the better in most cases.  Anything under 1.00 is considered overvalued and should be avoided.

Again, it’s not perfect.  But if investors had used it to measure the holdings in their portfolio, they could have avoided many of the bubbles, including the dot-com crash a decade ago.  Think of it as a preliminary screen; the companies that pass might deserve a closer look.  It’s also not going to make you rich unless you have a lot of time to compound your money and / or you are constantly adding new equity to grow the total funds working for you.  After all, if someone were 18 years old and began buying even boring blue chip stocks that were fairly or undervalued, they should retire at 65 with dignity and comfort, enjoying the fruits of their labor.

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