Introduction to the Benjamin Graham Fair Value Formula
The Benjamin Graham fair value formula is a well-known way to calculate the fair value of a company. This formula has been used for nearly 100 years, but this post will explain why it might not work as well today. This doesn’t mean the Benjamin Graham fair value formula is wrong; it just means that the market has changed over the years, and smart investors need to adapt to these changes.
Who Was Benjamin Graham?
Benjamin Graham was a famous economist and investor. He was born in Britain and later became an American. People call him the “father of value investing.” He wrote two important books about investing, called Security Analysis and The Intelligent Investor. Benjamin Graham was also Warren Buffett’s mentor at Columbia University. He was born in 1894 and died in 1976.
Using the AAA Corporate Bond Rate
In this post, we will use the AAA corporate bond rate in our examples and calculations. I’ve found that some people use the AAA corporate bond rate, while others use the AA corporate bond rate. For our examples, we’ll stick with the AAA corporate bond rate. This is important when using the Benjamin Graham fair value formula to make sure our calculations are correct.
Equation: (EPS(8.5+(1g))*4.4)/Y = Benjamin Graham Fair Value formula
Where…
- EPS = EPS Trailing Twelve Month
- 8.5 = P/E Ratio of a stock with 0% growth
- g = Share price growth rate for the next 10 years
- 4.4 = Graham determined this to be the minimum required rate of return
- Y = Current AAA corporate bond rate
Data inputs you’ll require…
- EPSTTM (TTM) = EPSTTM (TTM)
- 8.5 = 8.5 for the P/E Ratio
- Share = Share price today
- Share4 = Share price 4 years past
- 4.4 = 4.4 for the minimum required rate of return
- Y = The Current AAA corporate bond rate (Search for this with Google)
Equation 1
Equation 1 Description: We need to determine the total share growth rate over 4 years.
Equation 1: (Share – Share4)/(ABS(Share4)) = Total Share Growth Rate
Equation 2
Equation 2 Description: Now we need to determine the annualized share growth rate over those 4 years. This will equal “g” within the Fair Value equation.
Equation 2: (1+(Total Share Growth Rate))^(1/4)-1 = g
Equation 3
Equation 3 Description: Now we need to determine the Fair Value
Equation 3: (EPS(8.5+(1g))*4.4)/Y = Benjamin Graham Fair Value
Example 1: GOOGL (Google)
Data inputs you’ll require…
- EPSTTM (TTM) = 49.59
- 8.5 = 8.5
- Share= $1,731
- Share4 = $800
- 4.4 = 4.4
- Y = 2.28%
Equation 1
Equation 1 Description: We need to determine the total share growth rate over 4 years.
Equation 1: (Share – Share4)/(ABS(Share4)) = Total Share Growth Rate
Equation: (1,731 – 800)/(ABS(800)) = 116.38%
Equation 2
Equation 2 Description: Now we need to determine the annualized share growth rate over those 4 years. This will equal “g” within the Fair Value equation.
Equation 2: (1+(Total SHARE Growth Rate))^(1/4)-1 = g
Equation: (1+(1.1638))^(1/4)-1 = 21.28%
Equation 3
Equation 3 Description: Now we need to determine the Fair Value
Equation 3: (EPS(8.5+(1g))*4.4)/Y = Benjamin Graham Fair Value
Equation: (49.59(.085+(1.2128))*4.4)/.0228 = $2,849.95
Example 2: Meta Platforms (META)
Data inputs you’ll require…
- EPSTTM (TTM) = 6.48
- 8.5 = 8.5
- SHARE = $277
- SHARE4 = $115
- 4.4 = 4.4
- Y = 2.28%
Equation 1
Equation 1 Description: We need to determine the total share growth rate over 4 years.
Equation 1: (Share – Share4)/(ABS(Share4)) = Total Share Growth Rate
Equation: (271 – 115)/(ABS(115)) = 140.87%
Equation 2
Equation 2 Description: Now we need to determine the annualized share growth rate over those 4 years. This will equal “g” within the Fair Value equation.
Equation 2: (1+(Total SHARE Growth Rate))^(1/4)-1 = g
Equation: (1+(1.4087))^(1/4)-1 = 24.58%
Equation 3
Equation 3 Description: Now we need to determine the Fair Value
Equation 3: (EPS(8.5+(1g))*4.4)/Y = Benjamin Graham Fair Value
Equation: (6.48(.085+(1.2458))*4.4)/.0228 = $413.67
Summary
Although the Benjamin Graham Fair Value calculation may have been effective 100 years ago, times have changed. Here is why this calculation is no longer effective today.
- The 4.4% minimum required rate of return is too low. That is less than the average of the S&P 500 over the last 10 years which is about 10%. At Tykr, we prefer to use 15% as the minimum. 15% annual returns in the stock market is a reasonable expectation for most retail investors.
- We use the EPS Growth Rate as opposed to the Share Price Growth Rate because the EPS is not driven by emotions. The EPS is a result of the net income divided by the number of outstanding shares. Share price on the other hand can be driven by emotions. That’s why the share price growth rate is a misleading indicator.
- Bond rates no longer make a significant impact on the direction of stock movements. Although large institutions are primarily how the market moves up and down, the retail investor segment (you and I) is growing fast, very fast. Investing in the stock market has become increasingly popular over the last 10 years. The reason is, YouTube, Social Media, and Podcasts are making finance significantly more approachable and easier to understand and most retail investors don’t care about bond rates.
- Another point on bond rates is that some research has shown that as share prices rise, bond prices fall and when share prices fall, bond prices rise. Well, that may be true in some cases, but it’s not always true and the graph from thebalancemoney.com proves this point. Yes, in some years shares and bonds may move in opposite directions but in other years they move in the same direction. This is highly inconsistent.
Now, if you were to adjust the rate of turn from 4.4 to 15 and remove the bond rate completely, the entire equation would break and you would end up with a highly misleading Fair Value. As opposed to attempting to re-engineer the Benjamin Graham Fair Value, we have applied a more accurate Fair Value calculation to Tykr which was inspired by Phil Town. See the next article to learn more.