How to Calculate Intrinsic Value of Stocks using Benjamin Graham’s Formula?

Benjamin Grahams Formula to find intrinsic value of a Stock is one of the simplest and widely used valuation method that any investor can use.

In Case you are not familiar with Benjamin Graham, he is widely recognized as the father of value investing. He wrote the books on value investing, Security Analysis and The Intelligent Investor. He employed and mentored Warren Buffet and taught for years at UCLA.

Analyzing a particular stock involves dealing with the past, the present and future of any security issue. It Involves studying, analyzing business model of a company, financial results; then estimate future earnings of the company under various assumptions. Also involves analyzing possibilities and risks associated with a particular security. Job of the analyst is to apply certain standards of safety and make decision whether to buy a security at current price.

As Graham puts it: “In 44 Years of Wall Street Experience and study, I have never seen dependable Calculations made about common stock values that went beyond simple arithmetic mean or the most elementary algebra.”

It is generally not possible for a retail investor to carry out long, Intensive calculations using various valuation models to figure out whether a script is Overpriced, Under-priced or Fairly priced. In such case Benjamin Grahams simple formula to find valuation of growth stocks comes to the rescue of common investor. Benjamin Graham mentions the formula in his famous Book Security Analysis and The Intelligent Investor

Here,

• Earnings per Share (EPS) is the trailing twelve-month Earnings,

• 8.5 is the P/E ratio for a no growth company,

• Expected annual growth rate is the estimated growth rate over seven to ten years

One of the drawbacks of above formula is that it doesn’t account for Interest rate or Bond yield movement. As rate on high grade Corporate bonds decrease investment in stocks become more attractive and vice versa. Graham thought as Investor has choice between putting his money in common stocks or bonds, it was appropriate to take into account the rate of interest paid on High Grade bonds while determining the intrinsic value of the stock

In 1974, in the revised edition of The Intelligent Investor, Graham revised the formula to,

In this formula,

• 4.4 is the prevailing rate on High Grade corporate bonds listed on New York Stock Exchange in 1962

• Y is the current yield on AAA-rated corporate bonds.

If you test the formula you will see that bond yields affect the valuation of stocks. The lower the yield, Higher the price.

Tweaking the formula as per Indian Markets

In current Indian scenario we have to make formula work as per Indian markets to project stock prices as realistic as possible. If you use above formula for company valuation it will give very overvalued estimates for stock prices.

• Instead of using 8.5 as the no-growth P/E, we will use P/E of 7, as even if company has zero growth prospects but, if it is able to maintain cash flows and distribute dividends, its P/E is generally around 7 (of course you will find many exceptions to this, but it is general assumption)

• For Growth rate calculation we will use expected average growth rate for next five years in our calculations

• Multiplier 2 for Growth rate is too aggressive, at the time of graham he never experienced companies growing at 20-25 %, which is a very common thing for many companies. Instead of 2 we will reduce multiplier to 1.2 (still giving 20% advantage to growth as Indian markets highly values growth)

• In formula 4.4 is basically a risk-free rate in the economy, we can substitute it by five-year fixed deposit rate which is 8.5%

Margin of Safety

The difference between Intrinsic value and the current market price is the margin of safety. Greater the margin of Safety the safer is the investment. Warren Buffet recommends at least a margin of safety of 25%

Example –

Let us take example of Reliance Industries,

Following is the data for Reliance Industries,

• Current P/E ratio is 15.53

• EPS is 71.49

• Growth rate (5 years) is 5.49

• Y i.e. Indian Government AAA rated 10 years bond yield is 6.14%

Using Graham's Formula for Intrinsic Value of Stock,

Gives Intrinsic Value of Reliance Industries to be 1344 Rs/Share

Current market price of Reliance Industries is 1066

This gives margin of Safety = 26.14 % ( Means stock is Undervalued for CMP )

Applying Grahams Valuation Metrics to Nifty50 Stocks

I have Calculated Intrinsic values and Margin of Safety for Several Stocks (Majority of stocks are included in Nifty50)

Data is retrieved as per closing price on 27 March 2020

This formula won’t give you a true value as there are many long and complex valuation models used by analysts which account future earnings, debt, free cash flow. But it will give you a value close to a valuation model, which can help you to determine real value of a stock and help make sound decision which stocks are undervalued and whether you are paying fair price or not.