Finding Undervalued Stocks the Benjamin Graham Way

Benjamin Graham is basically known as the father of value investing.  He was the king of finding undervalued stocks.  His writings and work have influenced none less than the likes of Warren Buffet.  In fact, Warren Buffet has become the greatest value investor that we have ever known.  He has a knack for finding undervalued stocks.  Much of the foundation for his investment principles were based on the works of Benjamin Graham and David Dodd in the classic work entitled Security Analysis and other writings. 

Graham applied a formula to the stocks he was screening to determine whether they were candidates to be bought. Here is the formula.
V = EPS(8.5 + 2g)(4.4)/Y

On the face of it this may appear to be too complicated to pursue any further. However, when you break it down it is quite easy. Let's take a look at the parts.

V = Instrinsic value. This is the value that Graham's formula is saying that the stock may be worth.

EPS = Earnings per share. This is the trailing 12 month earning per share. You cannot use the anticipated P/E for this. In other words the money has to be in the bank. If however, you are looking at a stock that appears to be a value play because it has good trailing earnings but the future earnings are in question then cross this off your list.

G = Growth rate. This is the 5 year expected growth rate per year. This is not referring to the amount that it will grow for the entire 5 year period but the amount that it is expected to average for each of the next five years.

8.5 = No growth P/E. Graham assigned a standard P/E for stocks that are not expected to grow their earnings. If they will remain stagnant in earnings over the next year he would expect them to get a 8.5 P/E ratio.

4.4 = high grade corporate bond return. In the time and day that Graham put his formula together in the early 1960s, the average yield on high grade corporate bonds was 4.4%. Today that figure is slightly different but pretty close. You can either use the figure of today or stick with Graham's original number. High grade corporate bonds would include anything with an AA or AAA rating.

Y = yield on AAA rated corporate bond. Again you need to check what AAA corporate bonds are fetching these days then plug this figure into the equation. Currently this is around 5.5%. 

Once you plug all the numbers in you will get V, which is the intrinsic value of the stock.  The final step that Graham took was to divide the intrinsic value by the current price of the stock.  If the resulting number was less than one then this stock would not be a buy.  If however, the value was greater than 1, it would be a buy. 

When you do the computation and find stocks that are less than 1 you may want to write them down and figure out at which price they would be a value to you.  Then keep an eye on them for future investing possibilities.