Friday, March 4, 2011

Benjamin Graham's Formula for value investing

Correction for the past two weeks has come to an end. If you have bought some shares during that period, you have got yourself a bargain.

These few days, I have been thinking of Graham's Formula. Benjamin Graham, the father of value investing came up with a formula to do valuation for companies. The original formula looks like this:

Value = Earnings x (8.5 + 2 x growth rate)
Value: Current value of the company
Earnings: Earnings per share for the past 12 months. Be careful not to include any one time charges or income.
Growth Rate: Rate of growth expected for the next 7 to 10 years. You can use the growth rate for the past 7 - 10 years as a guide.

Even if we know the value of the company using the above formula, we will only buy the shares at a discount of that value. The reason for buying at a discount is to allow us to have a buffer for error.

I will use Cerebos as an example.
The growth rate for the past 5 years is 9.2%. So, I will use 9% as my growth rate.
The Earnings for trailing 12 months is $0.345 per share.
The Value will be
$0.345 x (8.5 + 2 x 9.2%) = $3.00

However, he has modified the formula in his book "Security Analysis" to include the corporate bonds rates. The reason for doing this is because economy keeps changing, therefore if bonds can offer better returns, we should invest in bonds instead.

The new formula is as follows:

Value = Earnings x (8.5 + 2 x growth rate) x 4.4 / Bond Rate
Bond Rate: I will use the most recent ones, 2%, offered by CapitaMall Trust.

The Value will be 
$0.345 x (8.5 + 2 x 9.2%) x 4.4/2 = $6.59

Current share price of Cerebos is close at $5.15, on 4 March. This share price is actually traded at a discount of 21.8%.

Should we trust Graham's modified formula or Graham's original formula?

I used the modified formula and bought some Cerebos shares when they were traded between $4.20 to $4.50. The current value, excluding dividend, is about 22% to 25% higher at today's closing price.

Now, you can use this above formula, and use them on some companies that are of your interest.

Kindly share your insights and calculations by commenting here.


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