One of the most difficult question to answer when it comes to value investing is how much a stock is worth? Which means, what is the fair value or the intrinsic value of a stock? One way to answer that question, and give us a concrete figure for the intrinsic value, is the Graham number.
Graham number is named after Benjamin Graham. The father of value investing and Warren Buffett’s teacher. Graham number takes into account the Earnings Per Share and Book Value Per Share of a company. Which means the goal of the Graham number is to know if the stock is cheap. Knowing if the company is a good company or has good management is out of the question. We are only talking about cheapness when it comes to the Graham number.
Here is the formula for the Graham number:
As you can see there is no computation if the business is a good business. Its just plain old value and the cheapness of the stock. Using simple variables and a simple formula using EPS and Book Value per share.
An Example
Let’s use a real life example. RFM Foods (RFM) is a food manufacturing and distribution company. They make flours, pasta products and dairy products like ice cream. The company has an EPS value of 0.30 and book value of 3.20. Let’s compute the Graham number.
square root (22.5 x 0.30 x 3.20)
Answer is 4.65.
The current stock price at market is 4.60. Just below the Graham number. We can conclude that RFM is currently undervalued by 0.05. What we want is so much discount from intrinsic value so we get a large margin of safety.
So that’s it for the Graham number. Simple isn’t it?