Have you ever worried about paying too much for a stock? As a dividend income investor, I have had this concern many times. Even though I like to take a long term approach to investing, I still don’t like to overpay to own a stock. There is no reason to overpay for a blue chip dividend stock.
So how can you tell what a fair price is to pay to own a stock? One method I have recently incorporated into my analysis is the Graham Number. Warren Buffett’s long time mentor, Benjamin Graham created a set of strict rules for screening value stocks. The results of the calculation are what Graham used to set the maximum price one should pay for a share.
The Graham number measures the value of a stock based on the company’s earnings per share (EPS) and book value per share. Any company that has a lower current share price than the Graham number is considered undervalued. On the other hand, a stock with a share price above this number is considered overvalued.
How to Calculate the Graham Number
Benjamin Graham was a value investor who believed that one should never buy a stock with a P/E ratio above 15. He also believed the price to book ratio (P/B) should not be over 1.5. The formula uses the product of both ratios (15 x 1.5 = 22.5), which allows the P/E or P/B to be a little higher as long as the combination of the two are still below the set threshold.
Based on these criteria, the formula to calculate the Graham Number is -
Fair Market Price = Square Root (22.5 x Book Value Per Share x EPS)
Some investors use book value per share while others go even further and use the tangible book value per share. The tangible book value is a more conservative number and removes things like good will from the equation. To keep things simple, we will use the standard book value per share for the purposes of this article.
The earnings per share (EPS) variable normally uses results from the past 12 months (TTM), although other scenarios could be used.
Graham Number Examples
Let’s take a look at two different examples of how the Graham number can be calculated. Both stocks listed below are found on the 2012 dividend aristocrat index. At the time of this writing, one of the stocks is undervalued while the other is overvalued according to the calculations.
Aflac (AFL)
- Book Value per Share – $27.00
- Earnings Per Share (TTM) – $3.94
AFL Fair Market Price = SQRT (22.5 x $27.00 x $3.94)
At the time of this writing, AFL had a fair market value = $48.92. Since the current share price is $44.07, this stock is undervalued and could be considered a “BUY” to value investors.
Cincinnati Financial (CINF)
- Book Value per Share – $29.28
- Earnings Per Share (TTM) – $0.97
CINF Fair Market Price = SQRT (22.5 x $29.28 x $0.97)
At the time of this writing, CINF had a fair market value = $25.28. Since the current share price is $31.47, this stock would be considered overvalued and could be considered a “SELL”.
Note – Book Value and Earnings per Share values were taken directly from Morningstar.com.
Using Fair Market Value
If you have ever wondered if a stock is overvalued or not, the Graham number is a tool that can help you decide. The formula calculates a fair market value for a stock based on the company’s earnings per share and book value. In addition to this formula, there are several other fair market value calculations that can be used to fit your investment strategy.
As with any financial ratio or statistic, investors should use a combination of them to make educated decisions on when to buy and/or sell a stock. As a dividend investor, I use other ratios that include P/E ratio, dividend payout ratio, yield on cost, current yield, among others to decide which stocks to buy. The Graham number can certainly help in my analysis but should not be used by itself to guide my actions.
Do you use any fair market calculations in your market analysis?
Full Disclosure – At the time of this writing, I own shares of CINF.
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