The Benjamin Graham Fair Value is a popular Fair Value calculation that’s been used for almost 100 years but this article explains why this calculation is no longer as effective as it used to be. This doesn’t mean Benjamin Graham is wrong, it just means the market has changed over the last 100 years and a good investor needs to adapt to these changes.
Benjamin Graham was a British-born American economist, professor, and investor. He is known as the “father of value investing”, and wrote two popular books on investing including Security Analysis and The Intelligent Investor. Benjamin Graham was Warren Buffett’s mentor at Columbia University. Benjamin Graham was born in 1894 and passed in 1976.
As you read below, you’ll see that the AAA corporate bond rate is used. Based on my research I’ve found that some investors use the AAA corporate bond rate and some investors use the AA corporate bond rate. In our examples and calculations, we’ll use the AAA corporate bond rate.
Equation: (EPS(8.5+(1g))*4.4)/Y = Benjamin Graham Fair Value
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 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 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 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 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 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 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: FB (Facebook)
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 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 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 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
Although the Benjamin Graham Fair Value calculation may have been effective 75 – 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 rate most financial advisors and wealth managers may return for their clients which is roughly 6%. This percent should be 15%. 15% annual returns in the stock market is a reasonable expectation for most retail investors.
- We use the EPS Growth Rate over 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 shares. Share price on the other hand can be driven by emotions. That’s why 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 5 years. In fact, the retail segment of investors is growing by 5% per year in the US compared to the financial advisor segment which is only growing by 1%. And that 5% growth in the US is slow compared to other countries. In India, the retail investor segment is growing by 20%. The reason is, Youtube, Social Media, and Podcasts are making finance significantly more approachable and easier to understand and 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, it’s not always true and the graph on this page proves that from 1930 – 2020. Yes, in some years shares and bonds may move in opposite directions but in other years they move the same direction. This is highly inconsistent. Similar to relying solely on the P/E Ratio and P/B Ratio, relying on the bond rates is misleading and should be removed from the equation.
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 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 my mentor, Phil Town. See the next article to learn more.