Learn How To Pick Underpriced Shares With The Graham Number
The Graham Number is a simple tool that you can use to decide if you are paying too much to buy a stock, provided you are a value-seeking investor. This calculation was postulated by one of the most famous m investors, Mr Benjamin Graham. He has laid out the theory in his book “The Intelligent Investor”.
Understanding the Graham Number
The Graham Number helps you to determine the upper limit on how much you should pay for a stock. Here is the formula to compute the graham number:
Price ≤ √(22.5 x EPS x BVPS)
EPS (Earning Per Share)=Total earnings/ Total number of shares outstanding
BVPS(Book Value Per Share)=Shareholder’s equity/Shares outstanding
Now, you want to determine if a company’s share price falls within a conservative range. Simply plug in the EPS and BVPS for that specific company into the above-mentioned formula.
The number you obtain signifies the maximum sum you can consider paying for a stock. If the actual price per share exceeds this amount, it indicates that the stock could be overpriced.
What’s interesting is that the formula was not actually provided in “The Intelligent Investor”. Graham actually provided seven important factors you should consider before investing in a stock. One of the factors included a relationship between the EPS and book value. The Graham Number was then created by analysts based on these recommendations.
In his book “The Intelligent Investor,” Graham elaborates on this approach and indirectly outlines the formula in the following ways:
- The current price per share should not exceed 15 times the average earnings over the past three years.
- The current price per share should not be more than 1.5 times the book value per share from the previous quarter.
The product of these multipliers is 22.5. Then, these principles have been further amalgamated into what is now referred to as the Graham Number. It is a convenient method for determining a reasonable stock price per share for defensive investors.
Let’s understand The Graham Number with an example.
Let’s suppose you are keen on investing in ONGC Ltd. Here is how we can find out if the stock is overpriced or underpriced by using the graham number.
The Earnings per share for ONGC is 30.39 and the Book value per share is 222.48. With these figures, we can compute the graham number as follows:
22.5 x 30.39 x 222.84 = 152126.122
If we take the square root of this number, it will come up to 390. The current price of ONGC is Rs 259. Since the current price of the ONGC stock is below this number, it means that the stock is underpriced at the moment and it’s a good time to buy this share.
Advantages and Disadvantages of using the Graham Number
The Graham number is a simple theory and very easy to implement. Let’s look at some of the pros and cons of using this method:
1. Efficient method: Calculating the graham number is an uncomplicated method that helps to gauge the valuation of a stock. It can be easily computed using a calculator.
2. Bargain prices: It also helps in the identification of companies that could be underpriced.
Disadvantages
1. Conservative approach: The graham number’s calculation aims to check if a company’s current stock price is below its intrinsic value. This approach cannot be used if you want to discover companies that might be offering good value.
2. Limited applicability: The Graham Number computation solely applies to companies with positive EPS and BVPS. Many companies that are not yet profitable yet have negative EPS and BVPS, rendering the graham number inapplicable to such cases.
3. Oversimplification: The graham number oversimplifies many of graham’s investment principles into a single metric, catering to investors who prefer a streamlined approach. Relying solely on one metric without taking into account other factors is not advisable.
Conclusion
If you are looking out undervalued stocks, you can use this tool to filter out some significant stocks from the universe of 1800 listed shares. You can further combine this tool with other investment strategies to further refine your stock selection process.
This tool is great because it provides a quick assessment that takes just a few seconds to calculate and offers insights into the current valuation of a company’s share price.
But you must remember that it shouldn’t be the sole method relied upon. Instead, you should use it as a valuable tool in constructing a lucrative investment portfolio.
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