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Using the Graham Number Correctly
Posted by: SerenityStocks (IP Logged)
Date: November 14, 2012 05:15PM
One of the most commonly used stock selection formulas these days is the Graham Number, which Graham actually did recommend (unlike the completely misunderstood Benjamin Graham Formula).
But again, there is a very large difference between how this calculation was recommended and how it is being used today.
The number itself is simple enough, and can be derived from criteria  and  from Graham's calculations for defensive stocks.
Quote:The optimum price for a defensive stock can easily be derived from this as the square root of (22.5 x EPS x BVPS), and this is the Graham number.
The problem however is that almost everywhere today, this number is used alone, while the other five supporting criteria for defensive stock selection are completely ignored.
The Complete Procedure
The complete stock selection procedure recommended by Graham is far more elaborate.
Step 1. First a stock is checked against all seven criteria for defensive investment above.
Step 2. If the stock fails to meet any one of the above criteria, it is then checked against the five criteria for enterprising investment (below).
Quote:This second set of criteria gives us an optimum price for a stock meeting the above conditions (an "enterprising" stock) as the lower of 120% net tangible assets (book value), or 10 times current earnings.
This is a number quite different from the Graham Number but equally, if not more valuable today.
Step 3. If a stock meets neither of the above groups of checks, it is finally checked against the last two criteria for investment as an NCAV or "bargain" stock (below).
Quote:This last set of criteria, for a stock that meets neither of the first two sets of criteria, gives us an NCAV stock. This is a stock selling for less than the value of its cash worth alone, and with positive earnings (no losses) in the last one year.
For a complete understanding of stocks and investing, a reading of "The Intelligent Investor" by Benjamin Graham is highly recommended. This is the book that Warren Buffett himself describes (in the preface) as "by far the best book about investing ever written."
If one were to apply all the Graham defensive criteria strictly, using 500 million in sales to count for inflation since 1973, there are plenty of stocks that meet most of them.
For example, these stocks meet all the defensive quality criteria but are simply too expensive:
And these stocks meet all the defensive criteria, including the pricing ones, but have a dividend record of less than 20 years:
Graham's various criteria are a fine balance of checks. There's no point if a stock meets just some of the criteria in a group and doesn't meet others.
For example, it's easy for a stock to show a great asset number while having lots of debt.
In any case, an automated analysis of all 4000 NYSE and Nasdaq stocks brings up plenty of stocks meeting all the necessary Graham criteria.
Also, choosing stocks that completely meet the latter of Graham's criteria is a far better approach than investing in stocks that incompletely meet the former criteria.
But just using the Graham Number, which satisfies only two of the seven defensive criteria, is not only excessively simplistic, but also potentially dangerous.
Disclaimer: The lists of stocks were arrived at by automated quantitative analysis and were not verified individually. Check for any recent changes in the data used before making an investment decision, especially for any recent stock splits.
Stocks Discussed: ALG, ALV, BG, BRC, CATO, CVX, FAST, FUL, HFC, INTC, JKHY, LAN,