When calculating the intrinsic value of a stock, a complete and rigorous analysis of the company is necessary, both financial and competitive. However, there are formulas that can help us have a rough idea of the value of a company without complicating our lives excessively. This is the case with Benjamin Graham's formula for calculating the intrinsic value of a stock. In this article I will explain Graham's formula along with its main advantages and disadvantages.
Benjamin Graham's formula for calculating the intrinsic value of a stock
The formula of Benjamin Graham to calculate the intrinsic value of a stock is as follows:
V = BPA * (8,5 + 2G)
- V: Intrinsic value of the action
- BPA: Net earnings per share
- G: Expected annual growth of net profit over the next 7-10 years
There is an updated Graham formula that also takes into account other factors such as the required return on investment. However, I prefer to use the simplified formula, as it serves us perfectly for our purpose of estimating a rough value without getting too complicated.
Relationship between PER and expected growth according to the Graham formula
Starting from Graham's formula, we can relate the Another reason maximum that we should pay for a share with the average annual growth that we expect in its earnings for the next few years.
PER = 8,5 + 2G
|PER maximum to pay||8,5||14,5||20,5||28,5||38,5||48,5||58,5|
According to the Graham formula, for a company without growth we should not pay more than a PER of 8,5. However, for a company with an expected growth for the next 7-10 years of 25% we could pay up to 58,5 times its profits.
In the following graph you can see the relationship between the maximum PER to pay and the expected average growth:
Relationship between PER and expected growth in the Benjamin Graham formula
Advantages of the Graham formula
The main advantage of Benjamin Graham's formula is its simplicity. Thanks to it, we can get an idea of the intrinsic value that a share can have in less than a minute.
The other advantage is that it takes into account two really determining factors when calculating the value of a stock, earnings and growth.
Drawbacks of Graham's formula
As you can imagine, the simplicity of this formula causes it to have quite a few drawbacks. Although there are others, I will focus on explaining what are, in my opinion, the two most important limitations of Graham's formula.
First, it does not take into account the company's indebtedness, which is one of the most determining factors when assessing a company's risk. A company without debt has more value than another leveraged, even if both have the same benefits and the same growth forecasts, since the first has a lower risk than the second.
In addition, it does not take into account other factors related to competitive analysis such as its position in the market, sector, competitive advantages, etc. Do not forget that fundamental analysis from a financial point of view is incomplete if it is not complemented by competitive analysis.
In short, what Graham's formula is for is to give an approximate value of a company, but nothing more. Do not think about investing solely based on this formula, since it is very likely that you will end up falling into the dreaded value traps.