Graham Number and Warren Buffett Portfolio

Graham Number is a concept based on Ben Graham's conservative valuation of companies. It calculates the intrinsic values of companies based on its earnings per share and tangible book value in a formula like this:

Graham Number = SquareRoot of (22.5 * Tangible Book Value per Share* Earnings per Share)

= SquareRoot of (22.5 * Net Income* Total Equity) / {Total Shares Outstanding

This is one of the ways to estimate the intrinsic value of business based on their book value and their earnings power.

Ben Graham actually did not publish a formula like this. But he wrote in The Intelligent Investor (1948 version) regarding to the criteria for purchases:

“Current price should not be more than 15 times average earnings of the past three years”

“Current price should not be more than 1.5 times the book value last reported. However, a multiplier of earnings below 15 could justify a correspondingly 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. (This figure corresponds to 15 times earnings and 1.5 times book value. It would admit an issue selling at only 9 times earnings and 2.5 times asset value, etc.)”

Unlike valuation methods such as DCF or Discounted Earnings, the Graham number does not take growth into the valuation. Unlike the valuation methods based on book value alone, it takes into account the earnings power. Therefore, the Graham Number is a combination of asset valuation and earnings power valuation.

In general, the Graham number is a very conservative way of valuing a stock. It cannot be applied to companies with negative book values.

We have added a new “Valuations” tab to the Guru Portfolio page, which lists the companies in the portfolios of Gurus relative to their Graham Number and other valuation methods such as Peter Lynch Fair Value, Intrinsic Value (DCF Projected), value indicated by median P/S etc.

Graham value is applicable only to the companies that have positive earnings and positive tangible book value. These are the companies in Warren Buffett’s portfolio that Graham numbers are calculated:

As we can see, as indicated by Graham Number, within Warren Buffett’s Portfolio, the companies that are undervalued are M&T Bank Corporation (NYSE:MTB), Torchmark Corporation (NYSE:TMK), Wells Fargo & Company (NYSE:WFC), and Bank Of Ny Mellon (NYSE:BK). Companies such as UPS (NYSE:UPS), Coca-Cola (NYSE:KO), Johnson & Johnson (NYSE:JNJ) and Washington Post (WPO) seems to be vastly overvalued.

Is this really the case?

Not necessarily. When applying any of those valuation methods, you need to be aware of their limitations. Please keep these in mind:

1. Graham Number does not take growth into account. Therefore it underestimates the values of the companies that have good earnings growth. We feel that if the earnings per share grows more than 10% a year, Graham Number underestimates the value.

2. Graham Number punishes the companies that have temporarily low earnings. Therefore, an average of earnings makes more sense in the calculation of Graham Number.

3. Graham Numbers underestimates companies that are light with book. Companies such as Moody’s (MCO) and Dun & Bradstreet (DNB) has negative book values. Graham Number cannot be applied here.

As indicated in our announcement of New Feature Added: Valuation Box, we also listed valuation methods such as Peter Lynch Fair Value, Median P/S Value etc. They are also listed under the new “Valuations” tab for gurus’ portfolios. To learn more on how each value is calculated, please read New Feature Added: Valuation Box and How to calculate the intrinsic value of a stock?

We will continue to write about these and explain in more details.

The new Valuation Tab is just one of the features we added to the Premium features we continue to add to Premium Membership. If you are not a Premium Member, why not take a 7-day Free Trial?

This is the link to the Valuation Tab of Warren Buffett’s Portfolio. You can check out all the valuation parameters there.

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