- Graham designed an elaborate stock selection framework for investors. This formula is not part of the framework, and is only mentioned briefly elsewhere to demonstrate past misjudgments by the market.
- Graham gave two warnings about this formula. But due to an omission in recent editions of The Intelligent Investor, this formula is often mistakenly used for stock valuation today.
- Graham's real framework is far more comprehensive and well-balanced. The 17 rules in the framework ensure both a qualitative and a quantitative Margin of Safety in one's investments.
Benjamin Graham - also known as The Dean of Wall Street and The Father of Value Investing - was a scholar and financial analyst who mentored legendary investors such as Warren Buffett, William J. Ruane, Irving Kahn and Walter J. Schloss.
Warren Buffett once wrote a detailed article explaining how Graham's record of creating exceptional investors (such as Buffett himself) is unquestionable, and how Graham's principles are everlasting. The article is called "The Superinvestors of Graham-and-Doddsville".
Buffett describes Graham's book The Intelligent Investor (in its preface) as "by far the best book about investing ever written".
Graham's Value Investing Framework
Graham dedicates two entire chapters of The Intelligent Investor to stock selection.
Chapter 14: Stock Selection for the Defensive Investor
Chapter 15: Stock Selection for the Enterprising Investor
Graham's first recommended strategy in these chapters - for casual investors - is to invest in Index stocks.
For more serious investors, Graham recommends three different categories of stocks - Defensive, Enterprising and NCAV - and 17 qualitative and quantitative rules for identifying them.
For advanced investors, Graham describes various "special situations".
The first strategy requires almost no analysis, and is easily accomplished today with a good S&P500 Index fund.
The last requires more than the average level of ability and experience. Such stocks are not amenable to impartial algorithmic analysis, and require a case-specific approach.
But Defensive, Enterprising and NCAV stocks can be reliably detected by today's data-mining software, and offer a great avenue for accurate automated analysis and profitable investment.
The 17 rules for these stocks ensure both a qualitative and a quantitative Margin of Safety when investing in them.
But most Graham analyses today only follow the quantitative part of Graham's recommendations (NCAV, Graham Number etc.) without the supporting qualitative criteria, which has led to the misconception that Graham only recommended cheap stocks.
Graham's entire value investing framework and its application today - including all 17 rules - is discussed in Investing For Beginners With Benjamin Graham.
The Misunderstood Intrinsic Value Formula
Graham specifies three different intrinsic value calculations - the Graham Number, the Enterprising price calculation and the NCAV - in his framework, with supporting qualitative rules for each.
But the intrinsic value calculation most attributed to Graham today is called the Benjamin Graham Formula, and is usually some variation of the following:
V = EPS x (8.5 + 2g), or
Value = Current (Normal) Earnings x (8.5 plus twice the expected annual growth rate)
Graham only mentions this formula briefly - in an unrelated chapter of The Intelligent Investor - to demonstrate why the market's growth expectations are rarely justified. This formula is not mentioned in the stock selection chapters, has no supporting qualitative checks, and is followed by two clear warnings.
The first is a footnote that says that this formula does not give any real intrinsic value for a stock.
Graham also wrote extensively about the unreliability of estimates in finance. His actual framework only uses objective figures from the past - including checks for past growth rates - and requires no assumptions about the future.
This formula uncharacteristically requires an "expected growth rate" - a subjective assumption - to arrive at an intrinsic value.
If we look at how this formula is actually used in the book (or in the scans given here), Graham uses this formula to calculate growth rates expected in the past - from past stock prices - and demonstrates how such expectations of growth are rarely justified.
The second warning - clearly labeled as such - then says that the formula is only intended as an illustration, and that such projections of growth rates are never reliable.
The stock selection chapters have no such warnings, and Graham clearly recommends the more comprehensive valuation methods described in them.
How The Misunderstanding Started
What seems to have started the misunderstanding is that the most commonly available edition of the book today is not the one originally written by Graham, but the new one with commentary by Jason Zweig.
In this edition, all the Foot Notes from the original book have been moved to the end of the book (endnotes) to make place for Zweig's commentary.
For example, if we look at the page with the formula in the new edition, we see that the footnote - where Graham cautions against using this formula for intrinsic values - is now missing.
In the new edition, the footnote is now at the end of the book - on Page 585 - where no one is likely to see it.
This missing footnote is probably what has led to present misunderstandings about the formula. The full warning (second scan above) is only given a couple of pages later, and is easy to miss.
Balancing Assets and Earnings
Every set of rules in Graham's real framework also includes a check for assets. This formula has no such checks.
For example, the Graham Number - the price calculation for Defensive quality stocks - is calculated as:
Services and other asset-light companies were common in Graham's time. In a calculation such as the above, lower assets can be offset by higher earnings and vice versa.
Graham designed a comprehensive, well-balanced framework that could assess all types of companies.
On the other hand, the Benjamin Graham formula is only useful for studying past misjudgments of growth expectations by the market. It cannot be used to calculate present intrinsic values, or to predict future growth rates.
Stocks clearing Graham's value investing framework today
Serenity provides two web-based stock screeners:
1. A free Classic Graham screener that lets you screen 5000+ NYSE and NASDAQ stocks by a strict 17-point Benjamin Graham Value Investing assessment.
2. An Advanced Graham screener that lets you screen the same 5000+ stocks by customized combinations of the Graham Number and Graham's 15 other Value Investing rules.
Given below is a list of stocks that clear Graham's 8 rules for Defensive investors - or 7 rules for Enterprising investors - today, along with all their Graham ratings:
(click to enlarge)
Symbols: UVV, HP, CSH, SCL, RS, HFC, GPRE, KGJI, CTCM, XIN, ATNI, ROC, FF, KBAL, UMC, GNI
The above list can be generated with the free Classic Graham screener as well. But the Advanced Graham screener has been used here to show more data for each stock.
Keeping It Simple
There are those who will continue to recommend stocks using variations of the v=eps*(8.5+2g) formula. They will defend it by saying that valuation is an art, that an intrinsic value is only an estimate, and that such warnings apply to all methods of valuation.
George Soros's Theory of Reflexivity states that our perception of the world is inherently flawed. The Theory of Reflexivity is also a direct repudiation of the Efficient Market Hypothesis (EMH); a hypothesis that Buffett too refuted in "The Superinvestors of Graham-and-Doddsville".
But while our view of reality may be far from perfect, those of us with a little more clarity tend to make slightly better decisions.
And success in investing depends on our ability to make fewer mistakes (maintain a Margin of Safety) and to make better decisions, based on hard facts.
"Operations for profit should be based not on optimism but on arithmetic." - Benjamin Graham
The facts about Graham's methods are all laid out in plain view above. When having to decide between the methods Graham recommended and the methods he warned against, it may help to remember Buffett's "Keep It Simple" principle.
Disclaimer: The list of stocks was generated with data mining algorithms and was not verified manually. Please verify the research - especially for any recent stock splits - before making an investment decision.