What Is the Graham Number?

The Graham Number is one way investors can decide if they are paying too much to buy a stock. The foundation of this calculation was laid by Benjamin Graham, who is considered one of the greatest investors of all time and was a mentor to Warren Buffet. In his famous book “The Intelligent Investor,” he lays out principles that evolved into what we now know as the Graham Number.

Definition and Example of the Graham Number

The Graham Number is a quick way for you, as an investor, to determine the upper limit on how much you should pay for a stock. This number is based on the principles of investing laid out by Graham.

The formula to find the Graham Number states that the price of a stock should be less than or equal to the square root of 22.5 times the earnings per share (EPS) multiplied by the book value per share (BVPS). Written out, the formula for calculating the Graham Number is:

Price ≤ √(22.5 x EPS x BVPS)

Suppose you want to find out whether the price per share of a company is within a conservative range. In that case, you can look up the EPS and BVPS for that company and plug it into the formula above.

The number you calculate is the max amount you should pay for a stock. If the price per share is higher than the number, the stock may be overvalued. You should think carefully before you decide whether or not to invest.

The formula for the Graham Number was not actually provided in “The Intelligent Investor.” Instead, in the book, Graham provided a number of important factors you should consider before investing in a stock, including a relationship between the values of earnings per share and book value. The Graham Number was created based on these recommendations.

How Does the Graham Number Work?

The Graham Number comes from one of seven criteria for the defensive investor to use to find quality investment opportunities. Of the seven criteria, Graham suggests searching for companies that have a moderate ratio of price to assets.

In “The Intelligent Investor,” Graham expands on this strategy and indirectly lays out the formula when he mentions a few key points:

• The current price per share should not be more than 15 times the average earnings of the last three years.
• The current price per share should not be more than 1.5 times the book value per share as of the previous quarter.
• Since a multiplier of earnings below 15 could justify a higher multiplier of assets, Graham concluded that “the product of the multiplier times the ratio of price to book value should not exceed 22.5.”

These points were combined into what is now known as the Graham Number. It is used as a quick way to calculate a fair price per share of stock for the defensive investor.

For example, you may want to determine whether ABC Company’s price per share is within buying range using the Graham Number. Currently, ABC Company is trading at $55 per share with an EPS of $4 and a BVPS of $20. To find ABC Company’s Graham Number, you’d multiply 22.5 x $4 x $20, then take the square root of that number. Here’s how it looks:

√(22.5 x 4 x 20) = √1,800 = 42.43

In this case, ABC Company’s Graham Number is currently lower than its current cost per share of $55. Since the Graham Number is the upper limit of what you should pay for a stock, you shouldn’t buy shares in ABC Company at $55 per share.

Pros and Cons of the Graham Number

Pros Explained

• Quick, easy method: Calculating the Graham Number is a quick and easy way to get an idea of the stock price valuation. It can easily be determined using a calculator or spreadsheet.
• Identify bargain stocks: Using the Graham Number will help you identify companies that are likely trading at bargain prices.

Cons Explained

• Conservative approach: The Graham Number calculation determines if the current stock price of a company is, theoretically, at or below intrinsic value. This may make it difficult to find companies with good value based on the formula.
• Only works for positive EPS and BVPS: Many companies are not yet profitable, which means their EPS and BVPS are negative numbers. The Graham Number calculation won’t apply to these companies.
• Oversimplification and reliance on one number: The Graham Number simplifies much of Graham’s investing advice to a single number for investors who don’t want to go through the steps of applying all his recommendations. It’s never a good idea to only look at one metric before making an investing decision.

What It Means for Individual Investors

Investors looking to find stocks trading at or below their fair value can use the Graham Number calculation to filter investment opportunities. The Graham Number will serve investors as a quick calculation that takes seconds to do and provides an idea of the current value of a company’s price per share.

Like other numbers and formulas for analyzing stock, the Graham Number is just one method you can use to find good investments. However, it should not be the only method you use. The Graham Number is one of many helpful tools you can use when building a profitable investment portfolio.