Benjamin Graham 's Formula

I - WHAT IS GRAHAM'S FORMULA ?

Benjamin Graham describes a formula he used to value stocks in the 11th chapter of the “Intelligent Investor”:

"Most of the writing of security analysts on formal appraisals relates to the valuation of growth stocks. Our study of the various methods has led us to suggest a foreshortened and quite simple formula for the valuation of growth stocks, which is intended to produce figures fairly close to those resulting from the more refined mathematical calculations.

Our formula is :

Intrinsic Value = Current Earnings x (8.5 + 2 x Expected Annual Growth Rate)

The growth figure should be that expected over the next seven to ten years."

Example n°1 : A stock is trading at 120$. Its current earnings are 8$ per share. The annual growth rate over the next 7 to 10 years should be around 7%. The Intrinsic Value is = 8 *( 8.5 + 2 * 7) = 180 $. The Margin of Safety is : (180 - 120) / 180 = 33%.

Example n°2 : the same stock is still trading at 120$, but its earnings are revised to 9$ per share and the annual long term growth rate should now be around 8%. The Intrinsic Value becomes = 9 *( 8.5 + 2 * 8) = 220.5. The Margin of Safety is : (220.5 - 120) / 220.5 = 56%.

Example n°3 : the same stock is trading at 120$, its earnings are 5.5$ per share, the annual growth rate around 6.5%.
The Intrinsic Value is = 5.5 *( 8.5 + 2 * 6.5) = 118. The Margin of Safety is : (118 - 120) / 118 = -1%.

A - A FEW IMPLICATIONS OF GRAHAM'S FORMULA
If we assume that Intrinsic Value = Price, then Graham's Formula is equivalent to : Price / Earnings = 8.5 + 2 x G.

1 - Price Earning Ratio (P/E) as a function of future growth (G)

In other words, the P/E for a no-growth company (G = 0) should be around 8.5.

2 - Implicit Growth derived from price and earnings.

From the fomula above, a P/E can be linked to G this way : G = (P/E - 8.5) / 2.