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Benjamin Graham's Misquoted Intrinsic Value Formula

October 22, 2012 | About:
SerenityStocks

SerenityStocks

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There is a surprisingly common misconception that Graham recommended evaluating stocks with the formula:

V = EPS x (8.5 + 2g), or

Value = Current (Normal) Earnings x (8.5 plus twice the expected annual growth rate)

An online search for "Benjamin Graham formula" will bring up dozens of stock screeners and analyst reports recommending stocks based on this formula.

(Note: Serenity too uses this formula, but to calculate the market's expected growth rate from the stock price, as Graham intended, and not the other way around.)

What Graham Actually Wrote:

Graham was completely against any kind of charting/technical analysis/forecasting. He always analyzed stocks based on past performance and wrote entire chapters on stock selection. This formula is not mentioned anywhere in them.

He only mentions this formula to show how unrealistic the market's growth expectations are, when seen retrospectively.

A few paragraphs after mentioning this formula, he wrote:

Warning: This material is supplied for illustrative purposes only, and because of the inescapable necessity in security analysis to project the future growth rate for most companies studied. Let the reader not be misled into thinking that such projections have any high degree of reliability or, conversely, that future prices can be counted on to behave accordingly as the prophecies are realized, surpassed, or disappointed.
There is even a footnote in the original 1973 edition of "The Intelligent Investor" (click here to see a scan) to clarify that this equation doesn't really give any "true value."

4.jpg

This footnote is missing in more recent editions of the book (it's now in the "endnotes" section, possibly the cause of the confusion). But the warning is present in the new editions as well.

Some Real Graham Stocks:

The stocks mentioned below, at their current prices, meet Graham's criteria for bargain issues, or net-current-asset stocks.

Given below is a sample list of stocks with the highest expected growth rates.

NameSymbolPrice/ EarningsPrice/ BookExpected annual growth rateGraham priceCurrent price
Courier CorpCRRC1,086.000.88538.75%$11$10.93
PC-Tel IncPCTI588.000.95289.75%$6.38$5.85
Prudential Bancorp of PAPBIP521.000.90256.25%$5.73$5.21
Axis Capital Hldgs LtdAXS478.710.71235.11%$35.48$33.81


As can be seen, these stocks come with very high PE values, which is also contrary to the myth that Graham only recommended cheap stocks.

Next is a contrasting list of NCAV stocks with the lowest expected growth rates.

NameSymbolPrice/ EarningsPrice/ BookExpected annual growth rateGraham priceCurrent price
Insignia Systems IncISIG0.500.85-4.00%$2.04$1.58
Network Engines IncNEI1.690.64-3.40%$2.17$1.43
First Bancorp (Puerto Rico)FBP1.700.53-3.40%$5.82$3.57
Amtech Systems IncASYS1.780.36-3.36%$12.34$3.89


The Best Stocks:

And finally, here's a sample list of what Graham called "stocks for the enterprising investor."

Enterprising stocks are not of defensive investment grade, but are of far better quality than simple bargain or NCAV stocks.

NameSymbolPrice/ EarningsPrice/ BookRequired annual growth rateGraham priceCurrent price
Hewlett-Packard CoHPQ5.630.90-1.44%$25.04$19.70
DeVry IncDV4.170.92-2.17%$25.42$19.23
Walter Energy Inc.WLT6.431.06-1.04%$41.77$38.89
WellPoint IncWLP7.540.77-0.48%$65.25$57.91


The Irony

As can be seen, the actual investment worthiness of a stock is quite independent of the market's expected growth rate for it, and far more complex to calculate.

The above lists are samples only; the complete list of stocks meeting Graham's various sets of investment criteria can be seen on The Benjamin Graham stock screener.

But the irony of this entire story is that the very formula with which Graham meant to show how unrealistic market expectations were, is the formula used the most today as the "Benjamin Graham growth stock formula!" There is perhaps good reason why Graham's protege and most famous student, Warren Buffett, said "Beware of geeks bearing formulas."

Disclaimer: The lists of Graham stocks were arrived at by automated quantitative analysis and were not verified individually. Before making a final investment decision, check for any recent changes, especially for recent stock splits.

About the author:

SerenityStocks
Find Stocks Meeting Benjamin Graham's Criteria Today - www.serenitystocks.com

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Comments

LwC
LwC - 2 years ago
V = EPS x (8.5 + 2g), or

Value = Current (Normal) Earnings x (8.5 plus twice the expected annual growth rate)

Note: Serenity too uses this formula, but to calculate the market's expected growth rate from the stock price, as Graham intended, and not the other way around.

Well if that's the case, why didn't Graham express the formula as:

g = (V/EPS - 8.5) / 2

One might refer to page 537 of the 4th edition of SA in which among other purposes, Graham uses this formula to show how different assumptions about the expected growth rate affects the calculated value (V), not the other way around as these authors assert. IMO one would be better served by reading some of Graham's interviews and articles on this subject to learn how Graham really intended for this formula to be applied, rather than rely on someone else's (mis)interpretation.

Furthermore it would appear that the authors of this article have not incorporated Graham's further elaboration of this formula, published in The Renaissance of Value: the Proceedings of a Seminar on the Economy, Interest Rates, Portfolio Management, and Bonds vs.Common Stocks (1974): 1-12, Charlottesville, VA: The Financial Analysts Research Foundation:

" This valuation--like those it purported to approximate--had the great defect of failing to allow for changes in the basic rate of interest. But the one development in the past decade that has had the greatest influence on stock values--and somewhat belatedly, on stock prices--has been the phenomenal advance in interest rates…

It would seem logical to me to make common-stock valuations vary inversely with representative current interest rates…"

Graham then introduces a modified formula:

V = EPS x (37.5 + 8.8G) / AAA interest rate

Graham proceeds to explain in some detail his thoughts about this issue.

Again, IMO one will be better served by relying on Graham's original material, rather than rely on (mis)conceptions of others.

Like so many other profound works, more people seem to pay lip service to the Intelligent Investor and Ben's other books than actually read them. As William Ruane is quick to point out, there are many misinterpretations of Ben's teachings. Graham himself once said that his books " have probably been read and disregarded by more people than any book on finance that I know of." Some of the ignored or misunderstood points are subtle, but important.

-- Benjamin Graham on Value Investing, by Janet Lowe

SerenityStocks
SerenityStocks - 1 year ago
Thank you for your comment, LwC!

Apologies for the late reply.

No email notification was received for your comment.

Quoting from the same page shown above:

"It is easy to make the converse calculation and to determine what rate of growth is anticipated by the current market price, assuming our formula is valid. In our last edition we made that calculation for the DJIA and for six important stock issues. These figures are reproduced..."

So as you can see, Graham only uses this formula to calculate growth rates, not intrinsic values.

Also, Graham's warnings:

"for illustrative purposes only"

"Let the reader not be misled into thinking that such projections have any high degree of reliability"

"we do not suggest that this formula gives the true value of a growth stock"

are all quite unambiguous.

And Graham only gives these warnings for this formula.

He strongly recommends the formulas in The Stock Selection chapters.

For a more thorough examination of this issue, please see Analysts Continue To Use Wrong Benjamin Graham Formula.

Thank you.
LwC
LwC - 1 year ago
"So as you can see, Graham only uses this formula to calculate growth rates, not intrinsic values."

IMO that's just nonsense, and I'm confident that anyone who has read even just some of Graham will agree that he is called the father of "value investing" because of his focus on methodologies for calculating an estimate of intrinsic value of companies. I don't know where you found the Graham quotes that you refer to in your response to my post, but they do not appear on any page that I referred to, contrary to your claim.

Furthermore in your response you ignored the two issues that I raised:

--If Graham intended that the formula is only for calculating growth rates as you adamantly assert, why didn't he express the formula that way?

--Why didn't you address the fact that Graham introduced a modified version of the formula?

Again IMO William Ruane's admonition that " …there are many misinterpretations of Ben's teachings" is illustrated in spades by your response.

SerenityStocks
SerenityStocks - 1 year ago
As already mentioned, the quote is from the same page that contains the formula , LwC.

A link to a scan of the page was given in this article earlier.

Now, the scan itself is included in the article too.

Thank you.
LwC
LwC - 1 year ago
IMO you are full of crap. You have edited your original article and also your original response to to my comment, adding and deleting material without making note of the edit and without referring to the original material. Nor have you provided any explanation as to why you did the edit. Though you claim in your last comment that part of the material you added was referred to in the original article by reference, it is not possible for me to confirm that claim. IMO your actions are unethical and dishonest.

Furthermore you have again ignored the two basic points that I raised in my original comment.

IMHO the GuruFocus administrators should take note of this and consider removing your articles from the forum.

SerenityStocks
SerenityStocks - 1 year ago
A copy of the original article - with the link, and without the image - can be seen at on the Google Cache here. A screenshot of the cache is also available here.

The edits on the original response were grammatical. The parts you quote and refer to in your reply (screenshot) are all still present.

LwC,

1. You first contended that Graham did not use this formula to calculate expected growth rates.

As can be seen on the screen shot, that's actually all he uses the formula for.

2. Then you said the quoted section was not anywhere in the book.

As you were already told, it was in the same page as the formula.

3. Then you said you could not verify that scan was linked to before.

You have the Google cache for verification.

So unless any further comments by you have any valid logical points - and are presented with the proper professional courtesy - you will not be receiving any further replies.

Thank you.
LwC
LwC - 1 year ago
"1. You first contented that Graham did not use this formula to calculate expected growth rates.

As can be seen on the screen shot, that's actually all he uses the formula for."

Ok, I see that the link you provided shows the original unaltered article. Thanks for that. However I note that the formula is stated, according to your own reference, to calculate the estimated value at various assumed growth rates; which is what I wrote above:

"Graham uses this formula to show how different assumptions about the expected growth rate affects the calculated value (V), not the other way around as these authors assert."

In your reference Graham states: "It is easy to make the converse calculation and to determine what rate of growth is anticipated by the current market price…"; which is the formula that I proposed above: g = (V/EPS - 8.5) / 2.

How you got to "So as you can see, Graham only uses this formula to calculate growth rates, not intrinsic values." [added emphasis] from that is beyond me. IMO Graham clearly intended to use the formula primarily to estimate value, and your assertion that he intended it only be used to calculate growth rates is just plain wrong and IMO contradicts Graham' own words. I asked you why, if your assertions are correct, Graham didn't express the formula that way. You have declined to explain.

"2. Then you said the quoted section was not anywhere in the book.

As you were already told, it was in the same page as the formula."

I wrote above: "One might refer to page 537 of the 4th edition of SA…", and you responded something to the effect that you are referring to the same page, but of course you weren't. Afterwards, with your clarification, I realized that while I referred to Security Analysis, in your response to me you were referring to The Intelligent Investor. No matter, they both say about the same thing, and IMO you are misinterpreting Graham's words.

Regardless, I note that you edited your response to me by deleting some of your remarks. You apparently did not see that I was referring to SA. I stand by my remarks that editing your original posts without leaving the original material and providing an accompanying explanation for the edit is unethical and dishonest. And IMO not very "professional" either, therefore not deserving of "courtesy."

And once again, why aren't you providing an explanation as to why you are not using Graham's modified formula, since he explained in some detail why he modified it. My guess is you didn't know about it, and that would be quite a lapse for someone who proclaims that you are the only one who correctly interprets Graham. Your continued lack of acknowledgement that Graham proffered a modified formula, and to provide some explanation as to why you think his modified formula is not a good as the original one that you use IMO is not very "professional."

And as for your remark about "proper professional courtesy", well IMO your proper professional response would have been to simply answer my query; in fact you still have not done so. So much for your claim to "professional courtesy."

I agree with you about one thing though: It is a waste time to continue any attempt at a dialogue with you.

Jae Jun
Jae Jun - 3 months ago

serenity,

The main point about the article is answered in Graham's own words.

"Note that we do not suggest that this formula gives the "true value" of a growth stock, but only that it approximates the results of the more elaborate calculations in vogue."

Emphasis added. Valuation is all about approximation. Graham never said, "never use this formula for valuation". He said it is an approximation. That's the same for DCF, Katsenelsons method of valuing stocks, Buffett's way of using EBIT as an approximation.

SerenityStocks
SerenityStocks - 1 month ago

Hello Jae Jun,

Thank you for your comment!
Your position is understandable since you run an investment tool based on this formula.

Graham gives these warnings with this formula:
1. "Warning: This material is supplied for illustrative purposes only".
2. "Note that we do not suggest that this formula gives the “true value” of a growth stock".
3. "Let the reader not be misled into thinking that such projections have any high degree of reliability".

On the other hand, he unequivocally recommends the methods in the unmistakably named "Stock Selection" chapters. They are discussed here:
http://www.gurufocus.com/news/262827/investing-for-beginners-with-benjamin-graham

Both articles have references, page numbers and scans of the relevant pages.
Readers can decide for themselves what Graham recommended, and what he warned against.

Thank you.

Please leave your comment:


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