The Graham Ratio

The Graham Ratio, also known as the Graham Number, is a formula created by Benjamin Graham to help investors quickly assess whether a stock is undervalued or overvalued based on two primary factors: earnings per share (EPS) and book value per share (BVPS). It serves as a simplified measure of intrinsic value, especially for conservative, defensive investors who prefer a margin of safety.

Graham Ratio Formula

The Graham Ratio, or Graham Number, is calculated as follows:

✓(22.5×EPS×BVPS)

In this formula:

• EPS = Earnings per Share, which measures the profitability per share.

• BVPS = Book Value per Share, which represents the net asset value per share.

• 22.5 = A constant that combines Graham’s recommended maximum P/E ratio (15) and Price-to-Book (P/B) ratio (1.5).

Purpose of the Graham Ratio

The Graham Number is designed to provide a quick assessment of a stock’s intrinsic value by combining earnings and book value. It helps determine if a stock is trading below its intrinsic value, which would suggest it might be undervalued.

By calculating this ratio, investors can find stocks that potentially have a margin of safety, meaning the stock price is lower than its intrinsic value.

Graham Ratio + Cash allocation

A business should consider the Graham Ratio when allocating cash to ensure investments align with a conservative valuation approach, offering a margin of safety. By identifying stocks trading below their intrinsic value (as calculated by the Graham Ratio), a company can potentially avoid overpaying and reduce investment risk. This ratio is particularly valuable for asset-heavy or stable industries, helping businesses allocate cash towards undervalued assets with stronger downside protection. This approach promotes disciplined, value-driven investment decisions, minimising exposure to market volatility and speculation.

Interpreting the Graham Number

If the stock price is below the Graham Number: The stock might be undervalued, presenting a potential buying opportunity. This suggests the stock price is trading at a level that provides a margin of safety.

If the stock price is above the Graham Number: The stock might be overvalued, indicating that it’s trading above what Graham would consider a reasonable price based on fundamental value.

Why Use 22.5 as a Constant?

Graham chose 15 as a reasonable maximum for the Price-to-Earnings (P/E) ratio and 1.5 as a maximum for the Price-to-Book (P/B) ratio. Multiplying these two numbers (15 x 1.5) gives 22.5, which forms the basis of the Graham Number calculation.

These limits align with Graham’s conservative investment philosophy, helping investors avoid stocks that are trading at overly high valuations.

Limitations of the Graham Ratio

Simplistic: The Graham Number is a simplified formula and may not fully account for nuances in certain industries or companies, especially high-growth sectors where earnings are reinvested and book value may not reflect intangible assets.

Applies Best to Stable, Asset-Heavy Companies: The ratio works best for companies with stable earnings and significant tangible assets (e.g., manufacturing or industrial sectors). It may not be as applicable for high-growth tech companies with low book values or volatile earnings.

Historical Data: The Graham Number uses historical EPS and BVPS, which may not fully capture future growth prospects or risks.

Summary

The Graham Ratio provides a quick, conservative estimate of a stock's intrinsic value by combining earnings and book value. It is most useful for finding undervalued stocks with a margin of safety in asset-heavy, stable sectors, allowing investors to avoid overpaying.