Graham number

One of the hot stock analysis tricks around now is the Graham number, named after that wild and crazy investor, Benjamin Graham. It even comes with a sexy formula:

$latex G = \sqrt {22.5 \times earnings \times book \; value}$

As with all such formulas, the first question to ask is, WTF? Followed closely by the second: 22.5 — WTF? Fortunately, Graham is a clear and precise writer, so we can answer these questions by going back to the source: The Intelligent Investor, by Benjamin Graham, HarperCollins 1973; ISBN 0-06-015547-7.

A simple rewrite begins to lift the fog (note that $latex 22.5 = 15 \times 1.5$):

$latex G = \sqrt {(15 \times earnings) (1.5 \times book \; value)}$

Graham thinks that $latex 15 \times earnings$ is a reasonable target price for a strong, safe, “defensive” stock. Likewise, $latex 1.5 \times book$ is a reasonable target price. If the company is earning 10% on book value, these target prices will be the same (and G will have the same value). Otherwise, G, the Graham number, is their geometric mean.

Now that we know what the formula is saying, we can decide whether, and how, to use it. The first clue is to be found in the title of chapter 14, where this concept is developed: “Stock Selection for the Defensive Investor”. Are you a defensive investor? Are you willing to forego speculation, and growth stocks? For at least a part of your portfolio? If the answer to these questions is no, then stop reading. This formula is not for you — move on to chapter 15: Stock Selection for the Enterprising Investor. (And if the answer to the last question is no, *head-slap*.)

A statue with dessert, photo by kattebelletje

Defensive investing goes beyond a simple buy and hold. For one thing, you focus on strong, safe, stodgy, boring companies, that are respectably large, with a strong balance sheet, strong earnings history, and strong dividend history. You’re not buying the market as a whole. Then, among those, you want to find the stocks trading at a significant discount to their Graham number, presuming (against Keynes) that the market will return to rationality while you are still solvent. Then you get safety from the balance sheet and earnings, income from the dividends, and dessert from the capital gains. And a little statue in an alcove at the Church of Value Investing.

The last part — waiting for the market to come to you — is the iffy part, of course, but if Ben Graham and Warren Buffet say it works, I’m not the one to tell them they’re wrong.