Ben Graham's Intrinsic value formula for stock valuations

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This formula is a definition. What quantity measurable in the real world does it correspond to. If we knew that we could see just how well this formula predicts. Without an empirical test to vet the formula the formula is just algebra.

ruveyn

EPS means earnings per share, which is defined as Earnings - dividends to preferred stock/average number of shares outstanding.

8.5 corresponds to the acceptable Price-earnings ratio of a blue chip company according to Ben Graham.

G is the expected growth in earnings for the next 5 - 10 years.

The other two are defined in the formula adequately.

The next calculation is to take the result and divide it by the current market price of a stock. If the result is under 1, the shares are overpriced, if they are over 1 they are not overpriced and the higher over 1 they are the better a buy are they provided external factors do not contradict it.

So, if we take a company with $5 in earnings per share, anticipated earnings growth of 5% and assume AAA corporate bond with a yield of 3% the calculation comes out to:

IV = 5*(8,5+2*5)*4,4/3 = $135,66 intrinsic value

If the shares are selling at $145, the next step is 135,66/145 = 0,9355 which means overpriced.

THat is a judgement, not a fact.

It appears that the formula does not make a substantial quantitative prediction.

ruveyn

The interesting thing is that Graham disciples are the some of the few people who have reliably beaten the market, some for over 50 years in a row (Warren Buffett). So despite that the formula doesn't make a quantitative prediction, it seems to be quite accurate. Non-withstanding that I suspect that some of them have modified it a little bit.

Securities valuation can never be a truly objective science, simply due to the fact that you can value stocks quite well from an objective point of view. In essence Net book value + dividend value of future cash flows per share. There are agency issues (which are starting to be quantitatively measured) different opinions about the future cash flows and such.

The interesting thing is that Graham disciples are the some of the few people who have reliably beaten the market, some for over 50 years in a row (Warren Buffett). So despite that the formula doesn't make a quantitative prediction, it seems to be quite accurate. Non-withstanding that I suspect that some of them have modified it a little bit.

Securities valuation can never be a truly objective science, simply due to the fact that you can value stocks quite well from an objective point of view. In essence Net book value + dividend value of future cash flows per share. There are agency issues (which are starting to be quantitatively measured) different opinions about the future cash flows and such.

And how many have lost money using this formula? Unless the loss side is compared accurately with the win side, no real claim can be made for this method.

ruveyn

When the formula was first introduced it was very effective. It is only one way to look at things.
Remember The Red Queen type of thing, if everyone uses this it will be far less effective.

Think of Kodak
Think of Apple

The management team is probably one of the key things.
If you have a company with no real engineers in the work force no matter what the management team does it will not be able to do engineering unless they outsource it.

You could have a company with the best most talented engineers in the world but have a management team who has no vision or desire to utilize there corporate natural resources, caught up in a yes-man culture, they will not be able to do any good engineering, this being the most common outcome.

I think the g term is quite crucial to the formula, as it is (by definition) an unknown.

How should an investor form expectations about future earnings?

Yeah, it's the same as Peter Lynch's approach of low P/E growth stocks and most other formulas that have been effective, yet when you have more people doing it it loses its effect very quickly.

I've actually been experimenting with switching some variables around, substituting some of the inputs and such, which is one of the reasons I started this thread. I figured that there has to be other people who are as market obsessed as I am.




When I value a company, I tend to include other things with the above formula, you mention management teams and engineering, I utilize some financial ratios, try to discover and quantify potential agency issues.




You're correct. The "G" is crucial to get correctly, otherwise it removes effectiveness. The trick with future earnings, is that you can't really look into the past for the last 5 or 10 years, without getting intimately familiar with the company. Even then, there are quite a few potential issues, such as new products, changes in "less noticeable" management that had extreme behind the scenes effects in the company,

With companies such as Apple and Facebook, there are always obsoleteness issues, in that there is substancial risk tied into new potential innovations within the industry. Funnily enough, this is also shared in more "tangible" asset companies as well, since having to redo a manufacturing fancily in a manufacturing company or redo your entire fleet in a shipping company has similar effects.

Tech has tended to have very small barriers to entry, whereas companies that operate more off tangible assets often have naturally higher barriers, not only in the form of capital costs but also in the form if supply limitations for manufacturing.

If you want to be really thorough I'd say investigate and analyze every product line the company has, present and future for costs and start the estimation from there. It's easy to work out a CAGR for the past 5, 8 or 10 years, but just because that's how it's been doesn't mean its going to continue like that, but unless something of great materiality changes, it's unlikely that a company that has been growing by 2% a year is suddenly going to grow by 10% for several years.

BTW Viper, INTJ.

I assume that this could be described as the "fundamental analysis" approach.

It really scared me when I found out that Warren Buffett got rich because he actually looked at the real world. Doesn't everyone? Oh, wait... they don't... I should have chosen a career as an investment banker... if I actually cared about money...



ISTJ in my case, although I never appreciated the Sensing/Intuition distinction in the Myers-Briggs. If I present a theory (thus an "N") and subject it to empirical tests (thus a "S") then I am *both*. No wonder that so many on the spectrum end up in these two categories...

I do favor fundamentals, but I'm very varied in which approach I use. I can never have a big enough toolbox. For instance, the fundamentals can scream "buy, I'm undervalued!" but if the trend channel is falling, you have multiple negative crosses and an RSI of 50 - 75, odds are it's going to become even more undervalued.

I'd say Buffett got rich because of being "disconnected" from the group-think, combined with forming his own opinions of the value of a company and doing so well. What he does is in essence contrary to the efficient market hypothesis.

I view it much in the same way that Thomas Kuhn viewed science and objectivity.



The way I understand it, the S is more concrete and the N is more abstract. I've found that my mind tend to generalize specifics into generalities, then apply those generalities to other specifics. For instance, the obsoleteness I mentioned in the previous post, is something that I read about the tech sector specifically, but which I also applied with small modifications to manufacturing and shipping.

One of the better and more peculiar ways of explaining the difference is,
If you can wake up in the middle of the night and go the bathroom without turning on the lights, you're probably an N. If you get overly annoyed and keep bumping into stuff, you're probably an S.

Of course, these are only preferences, as nobody could function without the other.

There is also extroverted iN and introverted iN etc.