Investing 101: How to Use Benjamin Graham's Valuation Equation

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(Written by Alexander Crawford. BVPS and EPS data sourced from Yahoo! Finance, all other data sourced from Finviz)

Value investors believe that stocks occasionally trade above and below their fair value but will inevitably move back to their fair value over time. Investors buy stocks that appear undervalued in the hope that they rally back up to their “fair price.”

Famous investor Benjamin Graham, the so-called “godfather of value investing” and former mentor of Warren Buffett, created a helpful equation to calculate the maximum fair value for a stock. Any stock trading at a significant discount to this number would be considered undervalued.

The Graham Number is derived using only two data points: current earnings per share and current book value per share.
The Graham Number = Fair Value of a Stock = Square Root of (22.5) x (TTM Earnings per Share) x (MRQ Book Value per Share).

This equation assumes that a stock is overvalued if P/E is over 15 or P/BV is over 1.5.

To help demonstrate this tool, we ran a screen on stocks with very high EPS growth over the past 5 years for those that appear undervalued relative to the Graham equation.

Even though these companies have seen high growth in EPS, they are still trading at steep discounts to their Graham number.

Do you think these stocks are undervalued? Use this list as a starting-off point for your own analysis.

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List sorted by potential upside implied by Graham number.

1. DDI Corp. (DDIC): Provides printed circuit board (PCB) engineering and manufacturing services primarily in North America. Market cap of $157.68M. TTM Diluted EPS at $1.00, MRQ Book Value Per Share at $4.75, Graham number at $10.34 (vs. current price at $7.48, implies a potential upside of 38.21%). Past 5-year EPS growth at 65.08%. Offers a good dividend, and appears to have good liquidity to back it up--dividend yield at 5.15%, current ratio at 2.57, and quick ratio at 1.91. The stock has had a couple of great days, gaining 13.62% over the last week.

2. KapStone Paper and Packaging Corporation (KS): Engages in the production and sale of unbleached kraft, linerboard, saturating kraft, and unbleached folding carton boards primarily in the Americas, Europe, and Asia. Market cap of $694.80M. TTM Diluted EPS at $1.79, MRQ Book Value Per Share at $9.83, Graham number at $19.90 (vs. current price at $14.75, implies a potential upside of 34.90%). Past 5-year EPS growth at 70.46%. The stock has gained 18.76% over the last year.

3. The Hackett Group, Inc. (HCKT): Operates as a strategic advisory and technology consulting firm primarily in the United States and western Europe. Market cap of $158.82M. TTM Diluted EPS at $0.35, MRQ Book Value Per Share at $2.92, Graham number at $4.80 (vs. current price at $3.60, implies a potential upside of 33.20%). Past 5-year EPS growth at 90.65%. The stock has had a couple of great days, gaining 5.96% over the last week.

4. Transatlantic Holdings Inc. (TRH): Offers reinsurance capacity for a range of property and casualty products. Market cap of $3.08B. TTM Diluted EPS at $2.63, MRQ Book Value Per Share at $67.76, Graham number at $63.32 (vs. current price at $48.94, implies a potential upside of 29.39%). Past 5-year EPS growth at 60.98%. The stock has gained 1.46% over the last year.

5. Quaker Chemical Corporation (KWR): Develops, produces, and markets formulated chemical specialty products for various heavy industrial and manufacturing applications. Market cap of $376.78M. TTM Diluted EPS at $2.84, MRQ Book Value Per Share at $19.77, Graham number at $35.54 (vs. current price at $28.56, implies a potential upside of 24.45%). Past 5-year EPS growth at 74.37%. This is a risky stock that is significantly more volatile than the overall market (beta = 2.58). Offers a good dividend, and appears to have good liquidity to back it up--dividend yield at 3.27%, current ratio at 2.28, and quick ratio at 1.59. The stock has lost 8.16% over the last year.

6. HealthSpring Inc. (HS): Operates as a managed care organization in the United States. Market cap of $2.60B. TTM Diluted EPS at $3.85, MRQ Book Value Per Share at $23.83, Graham number at $45.43 (vs. current price at $37.22, implies a potential upside of 22.07%). Past 5-year EPS growth at 70.05%. Might be undervalued at current levels, with a PEG ratio at 0.79, and P/FCF ratio at 12.87. The stock has gained 68.07% over the last year.

7. Buckeye Technologies Inc. (BKI): Distributes cellulose-based specialty products worldwide. Market cap of $1.03B. TTM Diluted EPS at $3.05, MRQ Book Value Per Share at $14.66, Graham number at $31.72 (vs. current price at $26.24, implies a potential upside of 20.88%). Past 5-year EPS growth at 125.31%. This is a risky stock that is significantly more volatile than the overall market (beta = 2.53). The stock has gained 96.33% over the last year.

8. Atwood Oceanics, Inc. (ATW): Engages in offshore drilling, and the completion of exploratory and developmental oil and gas wells. Market cap of $2.62B. TTM Diluted EPS at $4.03, MRQ Book Value Per Share at $24.34, Graham number at $46.98 (vs. current price at $39.57, implies a potential upside of 18.72%). Past 5-year EPS growth at 56.83%. The stock is a short squeeze candidate, with a short float at 10.08% (equivalent to 6.13 days of average volume). The stock has gained 42.64% over the last year.

9. Kirkland's Inc. (KIRK): Operates as a specialty retailer of home decor and gifts in the United States. Market cap of $195.42M. TTM Diluted EPS at $0.94, MRQ Book Value Per Share at $6.08, Graham number at $11.34 (vs. current price at $9.67, implies a potential upside of 17.27%). Past 5-year EPS growth at 155.92%. The stock is a short squeeze candidate, with a short float at 9.05% (equivalent to 9.03 days of average volume). The stock has lost 26.43% over the last year.

10. Ebix Inc. (EBIX): Provides on-demand software and e-commerce solutions to the insurance industry. Market cap of $620.22M. TTM Diluted EPS at $1.75, MRQ Book Value Per Share at $8.69, Graham number at $18.50 (vs. current price at $16.07, implies a potential upside of 15.11%). Past 5-year EPS growth at 57.95%. Might be undervalued at current levels, with a PEG ratio at 0.63, and P/FCF ratio at 10.95. The stock is a short squeeze candidate, with a short float at 36.38% (equivalent to 24.41 days of average volume).



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , Stocks


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