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Value investing with Graham number

/ 05:10 AM June 25, 2020

Legendary investor Benjamin Graham once said “there is no such thing as a good stock, there are only good stock prices.”

In a book he wrote during the Great Depression called “The Intelligent Investor,” Graham argued that the future value of an investment is a function of its present price. The higher the price you pay, the lower your return will be.

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Because there is always the risk of overpaying for a stock, Graham suggested that a way to play defensive was to buy stocks that were priced below their intrinsic values.

He said the fundamental value of a stock can be computed by taking the square root of the product of a stock’s price-to-earnings (PE) ratio, price-to-book value (PBV) ratio, earnings per share (EPS) and book value per share (BVS).

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He believes one must not pay a stock more than 15 times its earnings and 1.5 times its book value, so that the maximum factor used in the estimate should be 22.5 (e.g. 15 x 1.5).

For example, if we multiply the product of Robinson Land’s EPS of 1.96 and BVS of 20 by the factor 22.5, we will get 882.9.

By taking the square root of this figure, we will get the intrinsic value of the stock, based on Graham’s number, at P29.7 a share, which gives 38.7 percent discount at current share price.

If we apply the model used by Graham to Philippine Stock Exchange index (PSEi) stocks, which have median PE ratio of 12.2 and PBV ratio of 1.47, we will find that the market is undervalued by 9.8 percent.

In the past weeks, we have discussed in this column that every company has different risk profile. We know that a stock that trades above 15 times earnings may not be necessarily expensive or those that fall below 1.5 times book value may not be always cheap.

Following this argument, if we modify the PE and PBV ratios that were arbitrarily assumed by Graham in the model to reflect the prevailing risks of a company, we can see that the intrinsic value of a stock can also change significantly.

Back to the example above, if we multiply Robinson Land’s intrinsic PE of 8.7 against intrinsic PBV of 0.43, we will get a factor only of 3.73, lower than Graham’s factor of 22.5.

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Applying this factor against the stock’s EPS and BVS and taking the square root of the product thereafter, we will get the stock’s intrinsic value at P12.10 a share, which makes current share price overvalued by 50.7 percent. Remember that the riskiness of a stock is expressed by its cost of equity. The higher the risk, the lower the multiple of a stock.

With rise in economic uncertainties, the risk premium of a stock also increases. We derived Robinson’s cost of equity by adding premium on 10-year Philippine bond yield to get 11.46 percent. By converting this into ratio form, we obtained a PE multiple of 8.7.

The intrinsic PBV ratio is computed by multiplying the intrinsic PE of 8.7 against the prospective return-on-equity of the stock this year, which we assume at 4.9 percent.

If we apply this modified Graham model to the stocks of PSEi, reflecting the riskiness of the market, we will find that share prices are overvalued by median of 37.6 percent.

While the Graham number may be useful in selecting potential value stocks, bear in mind that the model does not include growth assumptions.

Given our challenging market environment, applying a conservative approach to picking stocks for long-term investment may be a good strategy.

The Graham number may not be the ideal model that provides accurate assessment of a stock’s intrinsic value but understanding the concepts behind it can help you find fundamentally strong companies.

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