Benjamin Graham's stock valuation methods

[TheMotorcycleBoy]

As yet another Stock Valuation method, in order to compare and contrast results achieved using Discounted Cash Flow and Earnings Power Value, I have recently come across "Benjamin Grahams Formula".

It does at first seem deceptively simple, but as with a lot of such things it's interpretation and application seems to be stuck in the mists of time.

Here is are a couple of internet descriptions/definitions:

https://en.wikipedia.org/wiki/Benjamin_Graham_formula
https://www.valuewalk.com/graham-formul ... -screener/
https://marketxls.com/ben-graham-formula/

Apparently the first crack at the formula goes like this:

V = EPS x (8.5 + 2g)

V = the value expected from the growth formulas over the next 7 to 10 years
EPS = trailing twelve months earnings per share
8.5 = P/E base for a no-growth company
g = reasonably expected 7 to 10 year growth rate

But then Graham modified the formula to account for rising interest rates/bond yields:

V = EPS x (8.5 + 2g) x (4.4/Y)

where the additional elements are (allegedly):
4.4= the average yield of AAA corporate bonds in 1962 (Graham did not specify the duration of the bonds, though it has been asserted that he used 20 year AAA bonds as his benchmark for this variable)
Y= the current yield on AAA corporate bonds.

Anyway, fear not, I'm not rushing to apply this formula everywhere I can.....though I do think that it's outputs are sometimes quoted in various subscription-based investment web services. (Stockopedia? But don't quote me on that please..).

However there are one or two aspects of the above which puzzle me:

1. When they refer to g does this mean the "expected annual growth rate" over the following 7-10 year period? Or is g meant as being the growth rate over the entire period? For example 41% growth over 7 or so years I believe equates to a 5% annual rate compounded...

2. The 4.4 figure for the average yield of corporate AAA bonds, looks silly. I appreciate the addition of a "weighting" factor to account that bonds are either yielding high or low, since this would obviously push equity desirability in the reverse direction. However, having 4.4 stuck in the formula forever, just seems to like mumbo-jumbo to me.

Has anyone else encountered this formula? If so, I'd love to hear other views on it and it's modern day interpretation/relevance.

Matt

[Hariseldon58]

From “Intelligent Investor”

Value = Current (Normal) Earnings × (8.5 plus twice the expected annual growth rate) The growth figure should be that expected over the next seven to ten years.

The footnote states that the formula does NOT give the true value of a growth stock but an approximation of more elaborate formulas currently in vogue.

Rather suspect that Ben Graham was not convinced by this...

[TheMotorcycleBoy]

From “Intelligent Investor”

Yes I have that book, I remember BG applies this formula or something very similar to a few firms over time in a couple of tables about 2/3-3/4 into the book. I think the odd one, vaguely follows the prophecy. Others don't... as usual conclusions are.... inconclusive.

Value = Current (Normal) Earnings × (8.5 plus twice the expected annual growth rate) The growth figure should be that expected over the next seven to ten years.

The footnote states that the formula does NOT give the true value of a growth stock but an approximation of more elaborate formulas currently in vogue.

Rather suspect that Ben Graham was not convinced by this...

In my opinion, the formula is just the price-over-earnings formula rearranged. That is:

P/E (ratio well just a number really from 5 - 25, and beyond) = Price/EPS

Applying Graham's formula to a firm and assuming 5% annual growth, meaning 41% over 7 years, meaning company's implied value is x by 1.41 over those 7 years. Now lob this figure into Graham's old version formula:

Price (Value) = EPS x (8.5 + 2x1.41)
=> Price/EPS = 11.32

now if you think of the scaling you'd receive on top of the 11.32 from the 4.4/Y value that lifts the ratio of probably into the usual range of PE figure - in my arrogant opinion.

My belief is that many have misunderstood the 4.4/Y scaling factor. That ratio is multiplied to apply a weight due to the body of investors loving or hating an equity investment at the current time relative to the yield they would see instead by putting their wonga into the bond market. So if Y is low, equities are overbought, and hence equity prices rise.

So my arrogant conclusion is that the formula is PE in disguise, and due to the myriad of magic numbers therein, probably has very little relation to the "intrinsic value" of a stock.

Matt