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Graham Number: Stock Screen for Dividend Investors
The Graham Number is part of Benjamin Graham’s stock screen for dividend investors. It uses price in relation to earnings and book value to identify the relative valuations of stable dividend stocks.
In The Intelligent Investor (amazon link) , Benjamin Graham delineates between two types of investors:
1. The Defensive Investor (Chapters 4, 5, & 14)
2. The Enterprising Investor (Chapters 6, 7, & 15)
The Graham Number pertains to the defensive investor. The defensive investor is a dividend investor looking for adequate long term returns through conservative investments.
Graham provided a check list of 7 criterion for the defensive investor to apply in searching for acceptable stocks. The Graham number is a great substitute for #6, and #7 on his list.
Graham’s Quality and Quantity Criteria
1. Large Stable Companies
Use a minimum market capitalization you feel comfortable with. I’ve seen recommendations from $500 million to 2 billion (what ModernGraham uses in their analysis).
2. Strong Financial Statements
a. Current assets twice current liabilities (Current Ratio > 2).
b. Working capital greater than long term debt.
3. Positive Earnings
No losses in the last 10 years.
4. Dependable Dividends
At least 20 consecutive years of dividend payments.
5. Growing Earnings
At least 33% increase in Earning Per Share (EPS) over 10 years.
6. Moderate Price / Earnings Ratio (P/E)
Three year average earnings should be less than 15 times the price.
7. Low Price to Book Value
Price / Book Value should be less than 1.5.
Here is where the Graham Number becomes useful. It combines #6 and #7. Graham did not want to exclude a stock because it did not meet one of the two criteria IF it was counteracted by the other metric.
Graham Number Calculation
Graham Number = Square Root of [22.5 x Earnings Per Share (EPS) x Book Value Per Share (BVPS)]
Earnings Per Share (EPS) = the average of the past 3 years (this is the original Graham calculation. Many services such as Y-Charts use the trailing twelve month (ttm) earnings without averaging the past 3 years).
Book Value Per Share (BVPS) = Shareholder Equity / Total Outstanding Common Shares
22.5 = the number set by Graham; it is the product of his maximum P/E ratio (15) and his maximum Book Value Per Share (1.5). By combining the two into one number (22.5) it allows some “wiggle room” for one or the other to be a little high.
The Graham Number is the maximum price to pay for a stock:
Example: Chevron (CVX)
Earnings Per Share (EPS) Last 3 Years = $10.86, $12.23, $12.22
3 Year Average = $11.77
Book Value Per Share (BVPS) = $82.60
CVX market price = $118.58
Graham Number = Square Root of [22.5 x 11.77 x 82.60] = $147.90
(Note: Some services (i.e. Y-Charts) use trailing twelve months earnings (ttm) instead of the average. Their Graham number is slightly different at $142.07.)
Conclusion: Since the price ($118.58) of CVX is significantly lower than the Graham Number ($147.90), it is a prime candidate for further research.
Pros and Cons of the Graham Number
The Graham number is relatively easy to find or figure. Because the defensive investor desires a portfolio in which he puts minimal effort, the Graham Number is an easy metric to use as a screen to avoid paying too high a price for a stock.
The Graham Number was formulated for stable dividend companies. It does not work well on growth stocks, companies with negative earnings, or companies with limited tangible assets (i.e cash, land, buildings, equipment, etc.).
Warning: The Graham Number is not meant to be used by itself. Graham intended that all 7 criterion would be used to screen a stock.
Why is the Graham Number Important?
The Graham Number is an additional valuation metric to identify stocks for further research. Since it’s simple and easy to find and/or calculate, it’s a convenient valuation tool to identify stocks that may be undervalued. As one of your first screens, it can be used to compare dividend stocks and eliminate the most expensive for further research.
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