There are several valuation metrics/methods that help identify
potentially undervalued stocks, and you may have tried a number of
them. But have you tried the Graham Number?
A quick check through the Graham Number can help determine whether
a company might be worth a look, before the market realizes how
good a deal it is.
What is the Graham Number?
It is named after the "father of value investing," Benjamin Graham,
who was a mentor of Warren Buffett. The figure takes into account
earnings per share and book value per share to measure a stock's
maximum fair market value. In other words, it is the upper end of
the price range that a defensive investor should pay for the stock.
Theoretically, any stock trading below its Graham Number is
The formula is as follows:
The Graham Number = Square Root of (22.5) x (TTM EPS) x (MRQ
Book Value per Share).
The 22.5 is included in the formula as a rule of thumb to account
for Graham's assumption that the price-to-earnings ratio should not
be over 15 and the price to book ratio should not be over 1.5 for
an undervalued stock. So, the number is generated as: (P/E of 15) x
(P/B of 1.5) = 22.5.
But keep in mind that a discount to the Graham Number is not always
worth getting excited about. Though the calculation is easier and
takes only a few minutes, it does not consider many fundamental
characteristics and ratios which are also important to identify
promising undervalued stocks.
It all depends on your investment strategy. So use a combination of
Graham Number and other fair market value calculations using other
financial ratios or statistics before making a final investment
We can't call this strategy "foolproof," but it can be an easy
starting point for your research.
Confirmation with Zacks Rank
A good way to confirm your choice is to look at the stock's Zacks
Rank. The Zacks Rank is a proprietary quantitative model that uses
trends in earnings estimate revisions to classify stocks into five
groups: Zacks #1 Rank = Strong Buy, Zacks #2 Rank = Buy, Zacks #3
Rank = Hold, Zacks #4 Rank = Sell and Zacks #5 Rank = Strong Sell.
The earnings estimates in the Zacks Model come from brokerage or
Now, if you see that your target stock holds a Zacks #1 or #2 Rank,
buying it could give you above-average returns.
(To learn more about the Zacks Rank, visit our
Three Stocks Undervalued by the Graham Number
While there are several value stocks that you may add to your
portfolio based on the above strategy in the current oversold
market, we believe the following three would be good additions:
Reliance Steel & Aluminum Co.
): A metals service center company that operates predominantly in
the United States and Canada. It holds a market capitalization of
- Earnings Per Share (TTM) = $4.89
- Book Value per Share (as of March 31, 2012) = $43.63
- Graham Number = SQRT (22.5 x $4.89 x $43.63) = $69.28
The stock is currently trading at $49.18 (closing price on May
21, 2012), implying a discount of 29.0% from the Graham Number or
fair market value. Currently, the company also has a Zacks #1 Rank.
MidWestOne Financial Group, Inc.
): A holding company for MidWestOne Bank that offers retail banking
products and services for individuals, businesses, governmental
units and institutional customers. It has a market capitalization
of $177.3 million.
Earnings Per Share (TTM) = $1.68
Book Value per Share (as of March 31, 2012) = $18.81
Graham Number = SQRT (22.5 x $1.68 x $18.81) = $26.66
The stock is currently trading at $20.94 (closing price on May 21,
2012), implying a 21.5% discount to the Graham Number. This is also
a Zacks #1 Rank company.
Access National Corp.
): With a market capitalization of $129.5 million, this is a bank
holding company for Access National Bank, which offers credit,
deposit and mortgage services to businesses and professionals in
the northern Virginia region and the Greater Washington, D.C.
- Earnings Per Share (TTM) = $1.21
- Book Value per Share (as of March 31, 2012) = $8.38
- Graham Number = SQRT (22.5 x $1.21 x $8.38) = $15.10
The stock is currently trading at $12.66 (closing price on May 21,
2012), implying a discount of 16.2% from the Graham Number. The
company also carries a Zacks #1 Rank.
The strategy is no doubt a smart and easy way to benefit from the
stock market. History affirms that this strategy has helped
generate strong returns during bear markets since the Great
Depression of the 1930s. And history always repeats itself!
One note of caution: you should not rest assured by targeting a
stock based only on the Graham Number. It is also important to try
and determine the reason for the undervaluation.
If the reason for a depressed stock price is difficult to find out
or understand, it could have the potential to materially reduce the
intrinsic value of the company and lead to a loss of capital.
Therefore, instead of searching for undervalued stocks based on
only quantitative factors or ratios first, it's better to identify
areas of the market where undervaluation is likely to remain due to
Disclosure: The author has no positions in any stocks
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