Using the Graham Number Correctly

One of the most commonly used stock selection formulas these days is the Graham Number, which Graham actually did recommend (unlike the completely misunderstood Benjamin Graham Formula).


But again, there is a very large difference between how this calculation was recommended and how it is being used today.


The Derivation:


The number itself is simple enough, and can be derived from criteria [6] and [7] from Graham's calculations for defensive stocks.

Summarized from Chapter 14 of "The Intelligent Investor" - Stock Selection for the Defensive Investor:


1. Not less than $100 million of annual sales.

[Serenity note: This comes to $500 million today based on the difference in CPI/Inflation from 1973]


2. (A) Current assets should be at least twice current liabilities.

(B) Long-term debt should not exceed the net current assets.


3. Some earnings for the common stock in each of the past ten years.


4. Uninterrupted payments for at least the past 20 years.


5. A minimum increase of at least one-third in per-share earnings in the past ten years.


6. Current price should not be more than 15 times average earnings.


7. Current price should not be more than 1-1â„2 times the book value.

As a rule of thumb we suggest that the product of the multiplier times the ratio of price to book value should not exceed 22.5.

The optimum price for a defensive stock can easily be derived from this as the square root of (22.5 x EPS x BVPS), and this is the Graham number.


The problem however is that almost everywhere today, this number is used alone, while the other five supporting criteria for defensive stock selection are completely ignored.


The Complete Procedure


The complete stock selection procedure recommended by Graham is far more elaborate.


Step 1. First a stock is checked against all seven criteria for defensive investment above.


Step 2. If the stock fails to meet any one of the above criteria, it is then checked against the five criteria for enterprising investment (below).

Summarized from Chapter 15 of "The Intelligent Investor" - Stock Selection for the Enterprising Investor:


[Serenity note: For issues selling at PE multipliers under 10]


1A. Current assets at least 11â„2 times current liabilities.

1B. Debt not more than 110% of net current assets.


2. Earnings stability: No deficit in the last five years covered in the Stock Guide.


3. Dividend record: Some current dividend.


4. Earnings growth: Last year's earnings more than those of 1966.

[Serenity note: This corresponds approximately to the earnings of 2007 today]


5. Price: Less than 120% net tangible assets.

This second set of criteria gives us an optimum price for a stock meeting the above conditions (an "enterprising" stock) as the lower of 120% net tangible assets (book value), or 10 times current earnings.


This is a number quite different from the Graham Number but equally, if not more valuable today.


Step 3. If a stock meets neither of the above groups of checks, it is finally checked against the last two criteria for investment as an NCAV or "bargain" stock (below).

Summarized from Chapter 15 of "The Intelligent Investor" - Stock Selection for the Enterprising Investor:


"Bargain Issues, or Net-Current-Asset Stocks"

"Price less than the applicable net current assets alone-after deducting all prior claims, and counting as zero the fixed and other assets."

"Eliminated those which had reported net losses in the last 12-month period."

This last set of criteria, for a stock that meets neither of the first two sets of criteria, gives us an NCAV stock. This is a stock selling for less than the value of its cash worth alone, and with positive earnings (no losses) in the last one year.


For a complete understanding of stocks and investing, a reading of "The Intelligent Investor" by Benjamin Graham is highly recommended. This is the book that Warren Buffett himself describes (in the preface) as "by far the best book about investing ever written."


To Conclude:


If one were to apply all the Graham defensive criteria strictly, using 500 million in sales to count for inflation since 1973, there are plenty of stocks that meet most of them.


For example, these stocks meet all the defensive quality criteria but are simply too expensive:





And these stocks meet all the defensive criteria, including the pricing ones, but have a dividend record of less than 20 years:





Graham's various criteria are a fine balance of checks. There's no point if a stock meets just some of the criteria in a group and doesn't meet others.


For example, it's easy for a stock to show a great asset number while having lots of debt.


In any case, an automated analysis of all 4000 NYSE and Nasdaq stocks brings up plenty of stocks meeting all the necessary Graham criteria.


Also, choosing stocks that completely meet the latter of Graham's criteria is a far better approach than investing in stocks that incompletely meet the former criteria.


But just using the Graham Number, which satisfies only two of the seven defensive criteria, is not only excessively simplistic, but also potentially dangerous.


Disclaimer: The lists of stocks were arrived at by automated quantitative analysis and were not verified individually. Check for any recent changes in the data used before making an investment decision, especially for any recent stock splits.