How to value companies with Benjamin Graham Formula?

How much is the company worth? Shall I buy shares now or shall I wait? If you do not know how to value the company correctly, you could make a costly mistake on your investment. Valuing a company is not an exact science Generally, the value is calculated using past...

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How much is the company worth? Shall I buy shares now or shall I wait? If you do not know how to value the company correctly, you could make a costly mistake on your investment.

Valuing a company is not an exact science

Generally, the value is calculated using past data from the balance sheet and future assumptions of the broader economy. Investors analyse a stock with a different outlook, which results in different prices. To value the company correctly, investors should give greater emphasis on previous information and rely less on their instincts.

There is no absolute value

Different valuation models explore different scenarios, resulting in different prices. Because Benjamin Graham formula looks into earnings only, it is ideal to value defensive companies. The recipe will not be useful to identify growth companies.

Therefore, if you want to find growth firms, you should use a different method.

The original Benjamin Graham Formula is incomplete

The original formula to find the value of the company was:

V = EPS x (8.5 + 2g)

where;

V= Expected value per share of the firm

EPS (Earnings per share) = the company’s last 12-month earnings per share

8.5 = P/E (Price to Earnings) ratio for a no-growth company g = long term growth rate of the company (7-10 years)

The original formula doesn’t take into account capital expenditures (i.e. money spent by businesses to maintain fixed assets and equipment). An illustration will help you understand.

Let’s assume there are two firms (Digital Media Co. and Construction Co.). They both have earnings of £1,000,000, but Digital Media Co. has a capital expenditure of £200,000 whereas Construction Co. has a capital expenditure of £800,000. Please see the comparison below:

 
  Digital Media Co. Construction Co.
Capital Expenditure £200,000 £800,000
Earnings £1,000,000 £1,000,000
Total Number of Shares 10,000 10,000
EPS (Earnings/Shares) 10 10
Growth 10% 10%

Value of Share (BG

Formula)

£106 £106

According to Benjamin Graham Formula, both companies are equally valued, making it difficult to choose the right stock. Assuming all else the same, Digital Media Co. is a better proposition than Construction Co.

The second issue with the original formula is that it ignores how much the firm is leveraged (i.e. Financed by debt). An illustration will help you understand.

Let’s assume we have two firms (Lehman Bros Co. and Microsoft Co.). They both have earnings of £5,000,000, but Lehmann Bros Co. has a total debt of £1,000,000 whereas Microsoft Co. has only £200,000 liability like below.

  Lehman Bros Co. Microsoft Co.
Total Debt £1,000,000 £200,000
Earnings £5,000,000 £5,000,000
Total Number of Shares 10,000 10,000
EPS (Earnings/Shares) £50 £50
Growth 10% 10%

Value of Share (BG

Formula)

£530 £530

Based on Benjamin Graham formula alone you will be tempted to buy the highly geared Lehman Bros.

The third issue with the original formula is that it was based on 1962 AAA corporate bond rates. To adjust the formula to today’s bond rates, we can adjust Graham’s formula to:

Where,

IV =           [EPS x (8.5 + 2g) x 4.4] / Y

V= Expected value per share of the firm

EPS (Earnings per share) = the company’s last 12-month earnings per share

8.5 = P/E (Price to Earnings) ratio for a no-growth company g = long term growth rate of the company (7-10 years)

4.4 = the average yield of AAA corporate bond in 1962 when the model has introduced Y = the current yield on AAA corporate bonds

10 Point Filter Method

To discover remarkable companies using the revised Benjamin Graham Formula, I would recommend the 10-point filter method.

The 10-point filter to find remarkable firms are:

  • Filter shares that have high-profit margins
  • Has market capitalisation more than $500 million
  • Current assets should be twice the current liabilities
  • Long-term debt should not exceed the net current assets
  • Regular dividend payments
  • The minimum increase of at least one-third in per-share earnings
  • Current share price should not be more than ten times the average earnings of the past three years
  • Current share price should not be more than 1.5 times the book value
  • Regular earnings growth yearly
  • Buying Level: the intrinsic value of the share using the revised Benjamin Graham Formula

Limitations of the revised formula:

  • Companies that have missed dividend payments recently will be not selected
  • Some reliable companies that have low-profit margins will be excluded from the final list
  • Firms that might have missed earnings growth due to the economic downturn will also be

Like any method, care should be taken on how you use them and your risk appetite. If you want to invest long term in defensive sectors, then I would recommend Benjamin Graham Formula with the 10 point filter method.

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