Graham Number
Category
Related Terms
Browse by Category
What Is the Graham Number?
The Graham Number is a conservative valuation figure that measures a stock's maximum fair value based on its earnings per share and book value per share.
The Graham Number is a figure that represents the maximum price a prudent investor should pay for a stock, according to the principles of Benjamin Graham. Often called the "father of value investing," Graham sought a simple, quantitative way to identify stocks that were statistically cheap relative to their fundamental accounting value. The number serves as a rough approximation of intrinsic value for companies with steady earnings and tangible assets. If a stock's market price is below the Graham Number, it suggests the stock is undervalued. If the price is above the Graham Number, the stock might be overvalued or speculative. It is important to note that this metric is a test of *price*, not business quality. A company could be trading below its Graham Number because it is in financial distress. Therefore, the Graham Number is best used as a starting point for further research rather than a final decision maker.
Key Takeaways
- The Graham Number is a formula developed by Benjamin Graham to determine the upper price limit for a defensive investor.
- It is calculated as the square root of 22.5 times Earnings Per Share (EPS) times Book Value Per Share (BVPS).
- A stock trading below its Graham Number is considered undervalued according to this specific metric.
- The constant "22.5" is derived from Graham's rule that the price-to-earnings ratio should not exceed 15 and the price-to-book ratio should not exceed 1.5.
- The formula works best for industrial and financial companies with tangible assets, and less well for modern technology or service companies.
- It is intended to be a screening tool, not a standalone buy signal.
How the Graham Number Works
The formula is derived from two of Graham's criteria for the "defensive investor": 1. The Price-to-Earnings (P/E) ratio should not be greater than 15. 2. The Price-to-Book (P/B) ratio should not be greater than 1.5. Graham suggested that the product of these two ratios should not exceed 22.5 (15 × 1.5 = 22.5). So, for a stock to be fairly valued: Price/Earnings × Price/Book ≤ 22.5 Solving for Price gives us the Graham Number formula: **Graham Number = √(22.5 × EPS × BVPS)** Where: - **EPS** is Earnings Per Share (usually trailing 12 months). - **BVPS** is Book Value Per Share (total equity divided by shares outstanding).
Step-by-Step Guide to Calculating the Graham Number
Calculating the Graham Number requires three pieces of information: the company's EPS, its Book Value Per Share, and a calculator. **1. Find the Earnings Per Share (EPS)** Look at the company's latest income statement or financial summary. Use the "diluted EPS" from continuing operations for the most conservative figure. **2. Find the Book Value Per Share (BVPS)** Look at the balance sheet. Take "Total Shareholder's Equity" and subtract "Preferred Stock." Divide this result by the number of shares outstanding. (Many financial websites list BVPS directly). **3. Multiply EPS by BVPS** (Example: $2.00 EPS × $10.00 BVPS = 20) **4. Multiply by 22.5** (Example: 20 × 22.5 = 450) **5. Take the Square Root** (Example: √450 = $21.21) **6. Compare to Current Price** If the stock is trading at $18.00, it is below the Graham Number ($21.21) and potentially undervalued.
Real-World Example: Valuing a Utility Company
Imagine a stable utility company, "PowerCo," with the following stats: - Stock Price: $35.00 - Earnings Per Share (TTM): $3.00 - Book Value Per Share: $25.00
Advantages of the Graham Number
**Simplicity:** It boils down complex valuation into a single, easy-to-understand dollar figure. It eliminates the need for complex Discounted Cash Flow (DCF) models with subjective growth assumptions. **Objectivity:** It relies purely on historical accounting data (earnings and book value), removing emotional bias from the valuation process. **Focus on Tangible Value:** By incorporating book value, it grounds the valuation in the company's actual assets, not just its earnings potential.
Disadvantages and Limitations
**Ignores Intangibles:** The formula is brutal for technology and service companies (like Microsoft or Google) that have massive earnings but relatively low book values because their assets are intellectual property, not factories. It will almost always say these stocks are overvalued. **Backward-Looking:** EPS and Book Value are historical figures. If a company's earnings are about to collapse, the Graham Number might still look attractive right before the stock crashes (a "value trap"). **Doesn't Account for Debt:** The formula looks at equity (book value) but ignores the debt load. A company could look cheap on a Graham Number basis but be on the verge of bankruptcy due to massive leverage.
When to Use the Graham Number
The Graham Number is not a universal tool. It works best for specific sectors.
| Sector | Suitability | Why? |
|---|---|---|
| Utilities | High | Asset-heavy, steady earnings |
| Manufacturing | High | Tangible assets (factories, inventory) drive value |
| Banks/Financials | Moderate | Book value is a key metric, but earnings can be volatile |
| Technology/Software | Low | Asset-light, value is in IP and growth |
| Services | Low | Few tangible assets, making book value irrelevant |
Common Beginner Mistakes
Watch out for these errors:
- Applying the Graham Number to a high-growth tech stock (it will always look expensive).
- Trusting the number blindly without checking debt levels.
- Using "Adjusted EPS" instead of GAAP EPS (Graham preferred conservative accounting).
- Forgetting that 22.5 is a somewhat arbitrary cap based on 1940s interest rates.
FAQs
It is the product of two limits Graham set for defensive investors: a maximum P/E ratio of 15 and a maximum P/B ratio of 1.5. 15 multiplied by 1.5 equals 22.5. It represents the upper bound of what he considered a reasonable price for a moderate-growth company.
You can calculate it, but it will likely be meaningless. Modern tech giants trade at high multiples of book value because their value comes from intangible assets (brand, ecosystem, data), which book value ignores. The Graham Number will almost always tell you to sell these stocks, even if they are good investments.
Technically, yes, if Earnings or Book Value are negative. However, you cannot take the square root of a negative number in this context. If a company has negative earnings or negative equity, the Graham Number is undefined, and the stock fails the test immediately.
This indicates the stock is "overvalued" according to Graham's conservative standards. It suggests the market is pricing in significant future growth that is not yet reflected in the current assets or earnings.
No. A stock can trade below its Graham Number and still go to zero (e.g., if the company is fraudulent or its assets are overstated). Always use it as a first screen, never as the final word.
The Bottom Line
The Graham Number is a classic, conservative valuation metric that serves as a quick litmus test for identifying undervalued stocks. By combining earnings power and asset protection into a single figure, it offers a disciplined upper limit for the price a defensive investor should pay. It is particularly effective for valuing traditional industrial, utility, and financial companies where tangible assets and steady profits are the norm. However, investors must recognize its limitations in the modern economy. The formula's reliance on tangible book value makes it less relevant for asset-light technology and service sectors. Furthermore, it does not account for debt, cash flow, or future growth prospects. For the intelligent investor, the Graham Number is a powerful initial screening tool—a way to find potential bargains in a crowded market—but it must always be followed by a thorough analysis of the company's financial health and competitive position.
More in Valuation
At a Glance
Key Takeaways
- The Graham Number is a formula developed by Benjamin Graham to determine the upper price limit for a defensive investor.
- It is calculated as the square root of 22.5 times Earnings Per Share (EPS) times Book Value Per Share (BVPS).
- A stock trading below its Graham Number is considered undervalued according to this specific metric.
- The constant "22.5" is derived from Graham's rule that the price-to-earnings ratio should not exceed 15 and the price-to-book ratio should not exceed 1.5.