Graham Number explained

August 11, 2024

The greatest investment advisor of the twentieth century, Benjamin Graham, taught and inspired people worldwide. Graham’s philosophy of “value investing” — which shields investors from substantial error and teaches them to develop long-term strategies — has made The Intelligent Investor the stock market bible ever since its original publication in 1949.

In value investing, a term often cited is the Graham Number.

The term is named after Benjamim Graham (1894-1976), the father of value investor and the author of The Intelligent Investor, from which the Graham Number came about.

In the chapter on Stock Selection for the Defensive Investor, he listed seven quality and quantity criteria suggested for the selection of specific common stocks.

The seven suggested criteria are:

  1. Adequate size of the enterpise (in an accompanying commentary on this, veteran journalist Jason Zweig said, “Nowadays, “to exclude small companies,” most defensive investors should steer clear of stocks with a total market value of less than $2 billion.” He added that “in early 2003, that still left you with 437 of the companies in the Standard & Poor’s 500-stock index to choose from.”)
  2. A sufficiently strong financial condition. “For industrial companies, current assets should be at least twice current liabilities.” In other words at least a 2-to-1 current ratio. “Also, long-term debt should not exceed the net current assets (or “working capital”). For public utilities, the debt should not exceed twice the stock equity (at book value).
  3. Earnings stability: Some earnings for the stock in each of the past 10 years..
  4. Dividend record: Continued dividends for at least the past 20 years.
  5. Earnings growth: Ten-year growth of at least one-third in per-share earnings, using three-year averages at the beginning and the end.
  6. Moderate price/earnings ratio: Current price should not be more than 15 times average earnings of the past three years.
  7. Moderate ratio of price to assets: Current price of stock should be no more than 1.5 times the book value (he mentioned this as “net asset value” in an earlier chapter) last reported.

Let’s zoom in on criteria (6) and (7) above as these are the two items from which Graham Number is derived:

Moderate ratio of price to assets: Current price of stock should be no more than 1.5 times the book value (he mentioned this as “net asset value” in an earlier chapter) last reported. “However,’” said Benjamin Graham, “a multiplifier of earnings below 15 could justify a corresponindly higher multiplier of assets.”

“As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5 times.”

Benjamin Graham elaborates: “This figure of (22.5 times) corresponds to 15 times earnings and one-and-a-half times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value etc.”

P/S Crtiteria (6) and (7) should therefore be read in conjunction. When book value exceeds 1.5 times, it has to be compensated by a fall in the price/earnings ratio of 15. The product of book value and the pice-earnings ratio should not exceed 22.5 times).

Now comes the calculation part. What is Graham number?

Market price of stock(P)/Earnings per share (EPS) x Market price of stock (P)/Book value per share (BVPS) = 22.5

Note: EPS must be average of the past three years.

P/EPS x P/BVPS = 22.5

Thus PxP=22.5xEPSxBVPS

P=√(22.5xEPSxBVPS)

P = Graham Number = square root of (22.5 x EPS x BVPS)

Note: EPS* = Net Income/shares outstanding

*average for the past three years;

And BVPS = Shareholders’ equity/shares outstanding.

The Graham Number is used as a test to identify stocks that are currently selling for a good price.

Graham Number example:

EPS average of past three years = $2.50

BVPS = $10.

Graham Number = √(22.5xEPSxBVPS) = √(22.5xEPSxBVPS) = √562.5 = $23.72.

Going by this Graham Number, any stock price below this example of $23.72 is an indication of a buy for a value investor.

Caution: Don’t ignore criteria (1) to (5).

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