How to Value Stocks Using The Graham Formula

Earlier today I was feeling kinda lonely. 😥 So I decided to buy some shares.
Ah yes. It sure feels good to have a bit of company. 😄 And that company is called Costco.

In this series of blog posts I’ll explain how I determine which stocks to add to my portfolio based on strategic valuation methods. 🙂

How to Value a Stock: The Graham Formula 

Today, we’ll look at one of the most common formulas to determine the intrinsic value of a company; it’s call the Benjamin Graham Formula, named after the famous value investor who taught Warren Buffett. 🙂

The Graham formula looks like the following:

This should give us an idea of how much we should pay to buy a stock. Let’s go over the variables.

V = Intrinsic value, or what the stock should be worth today.
EPS = Trailing twelve months earnings per share.
8.5 = P/E base for a no-growth company.
g = Expected long term earnings growth rate.

Is Costco Stock Undervalued or Overvalued?

This formula works best with blue-chip, large cap, value stocks. We will use Costco Wholesale Corporation as an example since I just purchased some recently. 🙂

So to find out the intrinsic value of Costco (NASDAQ:COST) we need to look up the earnings per share (EPS). This information can be found on Google Finance.  We see that it’s $5.41.

Next in the formula, we need the “g” value. We can find this information on the Nasdaq.com website, and see that it’s 10.71%.

Finally we can now plug everything into the formula to see the result.

So as of today, March 23rd, Costco should be worth around $162 per share according to the Benjamin Graham formula.

But of course the stock is actually trading at $167. This means Costco is currently overvalued because its shares are trading at a premium compared to the fair value we just calculated.

Investors can be flexible

Nevertheless, I still went ahead and purchased 10 shares of Costco this morning. The 3% premium I paid over the intrinsic value isn’t a big deal for me. Plus Costco recently announced an increase of membership fees to $60 per year. Like most other Costco shoppers I have decided to keep renewing my membership with them. But at least now I own 10 Costco shares, which entitles me (as a shareholder) to receive US $54 of after tax profits every year. This amount converted into Canadian dollars is more than enough to cover the expense of my annual Costco membership, haha. 😀

There’s also a revised version of the Benjamin Graham formula that looks like this:

This takes into considering the macroeconomic conditions such as interest rates. The “Y” variable stands for the current average yield on 20 year AAA corporate bonds in the U.S. This information can be found on Yahoo Finance’s bond yield page.

That’s basically an introduction into fundamental analysis. Now you know how to value a company. Ideally it would be best to find stocks below their Graham value. But at the same time do not rely on this formula alone to make a buy or sell decision. I also look at dividend growth, the peg ratio, and analysts’ ratings.

Finding the intrinsic value of a company

By using the Graham formula investors will have an increased probability to avoid bubbles similar to the peak in 2008 before the market correction. This is not a perfect tool or standard to live by. But the Graham formula can be a useful preliminary screener for potential stocks that might be worth taking a closer look at, especially for investors just beginning to learn about fundamental analysis. 🙂

———————————–
Random Useless Fact

Bananas float in water, as do apples and watermelons. But mangoes will sink.