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How to Find Intrinsic Value of Stocks Using Graham Formula cover

How to Find Intrinsic Value of Stocks Using Graham Formula?

How to find intrinsic value of stocks using Graham formula?

Valuation is one of the most important aspects while investigating any stock for investing. A good business might not be a good investment if you overpay for it. However, most valuation methods like DCF analysis, EPS valuation, dividend discount model etc requires little assumptions and calculations.

Luckily, there are also a few valuation methods available that are pretty simple to use in order to find the true value of a company.

In this post, we are going to discuss one such valuation method which is really straightforward and simple to use. And this valuation method is known as Graham formula. Here are the topics that we are going to discuss today:

  1. A brief introduction to Benjamin Graham
  2. How to find the intrinsic value of stocks using Graham formula?
  3. Pros and cons of graham formula.
  4. Real life example of valuing stocks from Indian stock market using graham formula.
  5. Closing thoughts.

Overall, this post is going to be really helpful for all the beginners who are stuck with the valuation of stocks and want to learn the easiest approach to find the true intrinsic value of companies. Therefore, make sure to read this post till the end.

Let’s get started.

1. A brief introduction to Benjamin Graham

Benjamin Graham was a British-born American investor and economist. He was a sincere value investor and often credited for popularizing the concept of value investing among the investing population. Graham was also:

Graham was a strict follower of value investing and preferred purchasing amazing businesses when they were trading at a significant discount.

In his book- Security analysis, Benjamin Graham mentioned his formula to pick stocks which become overly popular among stock market investors for valuing stocks since then.

graham formula security analysis

2. How to find the intrinsic value of stocks using Graham formula?

The Original formula shared by Benjamin Graham to find the true value of a company was

V* = EPS x (8.5 + 2g)

Where,

  • V* = Intrinsic value of the stock
  • EPS = Trailing twelve-month earnings per share of the company
  • 8.5 = PE of a stock at 0% growth rate
  • g = Growth rate of the company for the next 7-10 years

Anyways, this formula was published in 1962 and was revised later to meet the expected rate of return as a lot concerning the market and economy has changed since Graham’s time to present. The revised Graham formula is:

graham

During 1962 in the United States, the risk-free rate of return was 4.4% (this can also be considered as the minimum required rate of return). However, to adjust the formula to the present, we divide 4.4 by the current AAA corporate bond yield (Y) to make the formula legit.

Presently, the AAA corporate bonds are yielding close to 4.22% in the United States. (Source: YCharts). In order to make an apple to apple comparison, we’ll consider the bond yield for 1962 and current yield- both for the United States. Therefore, you can consider the value of Y equal to 4.22% currently, which may be subjected to change in the future.

Quick note: You can also use the corporate bond yield of India in 1962 and current yield to normalize the equation for valuing Indian stocks. In such case, the value 4.4. will be replaced by the Indian corporate bond yield in 1962 and Y will be the current corporate bond yield in India. Make sure to use the correct values.

Note: The Adjusted Graham formula for conservative investors.

Many conservative investors have even modified the Graham formula further to reach a defensive intrinsic value of the stocks.

For example, Graham originally used 8.5 as the PE of the company with zero growth. However, many investors use this zero growth PE between 7 to 9, depending on the industry they are investigating and their own approach.

Further, Graham used a growth multiple of ‘2’ in his original equation. However, many investors argue that during Graham’s time, there were not many companies with a high growth rate, such as technology stocks which may grow at 15-25% per annum. Here, if you multiply this growth rate with a factor of ‘2’, the calculated intrinsic value can be quite aggressive. And hence, many investors use a factor of 1 or 1.5 for the growth rate multiple in their calculations.

Overall, the adjusted formula of conservative investors turns out to be:

V* = EPS x (7 + g) * (4.4/Y)

3. Pros and cons of Graham formula.

The biggest pros of Graham’s formula is its ease and straightforwardness. You do not require any difficult input or complex calculations to find the intrinsic value of a company using the Graham formula. In a few easy calculation steps, this method can help the investors to define the upper range of their purchase price in any stock.

However, as no valuation method is perfect, there are also a few cons of Graham formula. For example, one of the important inputs of Graham formula is EPS. Anyways, EPS can be manipulated a little by the companies using the different loopholes in the accounting principles, and it such scenarios the calculated intrinsic value might be misleading. 

Another problem with Graham formula is that like most valuation methods, this formula also completely ignores the qualitative characteristics of a company like Industry characteristics, management quality, competitive advantage (moat) etc while calculating the true value of stocks.

4. Real life example of valuing stocks from Indian stock market using graham formula.

Now that you understood the basics of how you can value stocks using graham formula, let us use this formula to perform a basic stock valuation of a real-life example from the Indian stock market.

Here, we are taking the case study of HERO MOTOCORP (NSE: HEROMOTOCO) to find its true intrinsic value using the Graham formula. For Hero Motocorp,

  • EPS (TTM) = Rs 186.29
  • Expected growth (for the next 5 years) = 9.89%

(Past 5-year EPS growth rate per annum (CAGR) of Hero motocorp is 14.14%. Taking 30% safety on this growth rate as it is a large cap, we can estimate a conservative expected future growth rate of 9.89% for next few years).

Now first, let us find the intrinsic value of Hero motocorp using the original Graham formula,

V* = EPS x (8.5 + 2g)
= 186.29 x (8.5 + 2*9.89) = Rs 5268. 28

Now, using the revised formula with conservative zero-growth PE of 7 and growth multiple of one, the intrinsic value of Hero motocorp turns out to be:

V* = EPS x (7 + g) x (4.4/4.22)
= 186.29 x ( 7 + 9.89) x (4.4/4.22) =3280.65

At the time of writing this post, hero motocorp stock is trading at a market price of Rs 2961.90 and PE (TTM) of 15.90.  Therefore, by using Graham formula, we can consider this stock to be currently undervalued.

Disclaimer: The case study used above is just for educational purpose and should not be considered as a stock advisory. Please research the company carefully before investing. After all, no one cares more about your money than you do.

You can also use Trade Brains’ online GRAHAM CALCULATOR to perform your calculations fast.

5. Closing thoughts.

An important point worth mentioned here is the concept of margin of safety that Benjamin Graham repeatedly taught in his books.

In simple words, according to the concept of margin of safety, if the calculated intrinsic price of a company turns out to be Rs 100, always give your calculations a little safety and purchase the stock at a 15-25% below that calculated value, i.e. when the stock trades below Rs 75-85.

Overall, Graham formula is a fast, simple and straightforward method to find the intrinsic value of stocks. If you haven’t tried it yet, you should definitely use this valuation approach while performing the fundamental analysis of any stock.

Investing for Beginners

If you are new to investing, you can learn how to perform stock valuation and pick profitable shares for consistent returns in the Indian stock market with Trade Brains flagship course ‘How to pick winning stocks’. It is a self-paced online course with lifetime access so that you can learn on your own schedule. This course is currently available at a discount. Check out more here. Happy investing!!!

Additional credits: Vasanth (for data inputs in Graham Formula)

Hi, I am Kritesh, an NSE Certified Equity Fundamental Analyst. I’m 23-year old and an electrical engineer (NIT Warangal) by qualification. I have a passion for stocks and have spent my last 4+ years learning, investing and educating people about stock market investing. And so, I am delighted to share my learnings with you. #HappyInvesting

Comments
  • Gopinath R.S. says:

    Looks very interesting.
    It will be worth to find Intrinsic Value of Indian (Nifty 500) stocks, periodically, and publish it for the benefit of investors
    Gopinath.

    • Hi Mr. Gopinath. Thank you for your comment. I would love to help but it’s really not possible to maintain such reports. After all, earnings change every quarter and it would be very hard to track and calculate the intrinsic value of all 500 companies.

  • Sneha says:

    Hi Kritesh. Where can I find government bond yield history for India?

  • Rajeev says:

    Hi Kritesh, why do you take US bond yields in the above formula?, why not Indian bond yield?

    • Hi Rajeev. You can take either, Indian bond yields would even work better. It’s just to normalize the values from Graham time to present. Anyhow, many analysts believe that since we are using his formula, we should normalize it w.r.t his country (United States) so that the basic equation remains the same. The thing here is that there was no bond yield in the original equation. It was just later added to normalize the values. If you want, you can even use the original formula, V* = EPS (8.5 + 2g). However, every analyst/investor uses his own adjustment. I hope it helps.

  • sujithkumar says:

    Hi Kritesh,
    Thank you very much for your value adding article on finding out the Intrinsic value by Graham formula. For getting the 5 year expected growth rate,you have recommended to follow yahoo finance. But many stocks analysis values are not available in this site. Could you tell me how to calculate it or suggest other financial website to get those data. Thanking you.

    • Hi Sujith. Yes, yahoo finance doesn’t provide the expected growth rate for all the companies (it’s good only for large-cap companies). The thing is that different investors use different approaches to find the expected growth rate of a company. Few of the common ways are by looking at the historical growth rate for the earnings/profits, reading the analysts reports to find out what they are forecasting, peeking in the company’s annual report/latest news to find out what the management/CEO is saying regarding the company’s growth rate in upcoming years etc.

  • anil dcunha says:

    hello kritesh,

    could you guide as to how to get the expected growth rate (can be get from screener)

    also pe of stock with zero growth how to ascertain if the current PE is given in table available in screener

    and lastly growth rate multiple how to derive.

    • Kritesh Abhishek says:

      Hi Anil. For the expected growth rate, you can look into the historical EPS on SCREENER. However, it’s mostly based on your own studies and assumptions. I mean, even the past growth rate for last 3, 5 and 10 years will be different. What to choose, will be based on your studies, future expectations, industry etc. Next, zero growth PE may also vary from industry to industry. For example, the technology industry might have a higher PE compared to the utility sector. Finally, take a growth multiple of one to reach a conservative value. I know this answer is a little vague, but forecasting the future earnings of a company will require few assumptions. I hope it helps. Cheers!!

  • TUSHAR SHRIPAD DESHCHPUGULE says:

    Past 5-year EPS growth rate per annum (CAGR) of Hero motocorp is 14.14%. Taking 30% safety on this growth rate as it is a large cap, we can estimate a conservative expected future growth rate of 9.89% for next few years).

    I just did not understand — this equation of 9.89% . How did you do it ?

    • Hi Tushar. I simply took 30% discount on the growth rate of Hero motocorp. Therefore, considering a growth rate of 0.7 * 14.14, I am making a conservative assuption. The thing is that past performance doesn’t gurarntee the future. This company may even grow faster than the historical performance or slow down- No one can exactly predict the future. But by being conservative, we can reduce the risk.

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