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 including 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.
What is the Benjamin Graham Fair Value Formula?
The remainder of this post breaks down the math behind the Benjamin Graham Fair Value Formula or also known as the Benjamin Graham Fair Value Equation.
To start, Benjamin Graham used the AAA corporate bond rate. 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.
Benjamin Graham Fair Value Formula = (EPS(8.5+(1g))*4.4)/Y
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: Alphabet (GOOGL)
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.
- Low Expected Return – 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 value investors.
- EPS is greater than Share Price – 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 are no longer a factor in Share Prices – 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.
Tykr Fair Value Calculation
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.
If you log into Tykr and click on the Projections tab of a stock, you may see a comparison between these four fair value equations.
- Tykr Fair Value
- Rule #1 Fair Value
- Graham Fair Value
- Discounted Cash Flow
If you want to Buy and Sell stocks with confidence, we welcome you to join Tykr for free!