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Grahams Formula - Workings

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  • Grahams Formula - Workings

    I thought I'd provide an explanation of how to use the basic Graham formula, as some of the descriptions on the web can be a bit vague.

    The Graham formula is a very basic tool which can be quickly applied to get a feel for a stock, to see if it's worth investigating further.

    Let's take an imaginary company called Baileys Amazing NZ Share Trading Investment Company, or BANZSTIC, appreviated down to 'BS' for short.

    First, the Graham formula -

    V = EPS (8.5 + (2 x G))

    Where,

    V = valuation you come out with. You can work in dollars or cents, (eg $1.10 or 110c).

    EPS = Earnings per share. Again, you can work in dollars or cents, however the answer will be relative to whatever unit you use. For example, if you use cents in your EPS, your valuation will be in cents to. Take a look at the practical example later on. Note, this is the trailing 12 months EPS.

    8.5 = This is a price to earnings ratio (PE ratio) that someone is willing to pay by default for a zero growth company. It is simply a multiplier in the equation, reflecting a mutliple of earnings one is willing to pay for a company. This number could be changed depending on how much you're willing to pay for earnings (after a study, Graham found 8.5 an appropriate multiple to pay for earnings).

    2 x G = G is growth and is used as a percentage, not as a decimal. For example, growth of 15% would be entered simply as 15, not as 0.15. The 2 is another multiplier, based on the fact growth is worth paying for, again this number could be changed depending on how aggressively you want to value growth. This growth is an estimate of the next 7-10 years.

    So let's use BS company as an example. From the annual report, you find an EPS of 20 cents. Let's work in dollar terms and call this $0.2. You estimate growth to be 15%, as BS is a great company (of course). Remember this stays as 15.

    If we plug these numbers into the formula;

    V = EPS (8.5 + (2G))

    V = $0.2 x (8.5 + (2 x 15))

    V = $0.2 x 38.5

    V = $7.7

    Baileys Amazing NZ Share Trading Investment Company has an underlying valuation of $7.7. This could then be compared to the current shareprice to see if the stock is cheap, expensive or accurately priced.

  • #2
    Growth at 15% and a PE of 38.5 .......hmmm

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    • #3
      Originally posted by Winner69 View Post
      Growth at 15% and a PE of 38.5 .......hmmm
      Haha, I think the clue might have been in the name of the company - abbreviated down to 'BS'.

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      • #4
        OK, I have the formula for working out what growth the market is anticipating, based upon an earnings per share figure and a valuation (the current shareprice).

        G = (0.5V/EPS) - 4.25

        For example, using the example from the start of the thread, Baileys company,

        The V (valuation) was $7.70
        Growth G was 15% so 15
        Earnings per share (EPS) were 20 cents, so $0.2 to keep the same unit (dollars) as the valuation.

        Plugging this into the rearranged formula to get growth, we get;

        G = ((0.5 x 7.7)/0.2) - 4.25

        G = 15

        So it works.

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        • #5
          Growth rate slowing to 15%

          EPS of 20 something cents.

          Almost sounding a bit like ATM Winner69

          Spooky eh.

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          • #6
            Thanks Bailey I have found The Intelligent Investor a bit hard to read so is a book that I plan to read again. However thanks to percy I found out The Zulu Principle from Jim Slater which is an easy book to read. I just wanted to share this as it seems Graham's book very well known and Slater's one seems quite the opposite.

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            HLG

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