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James Dennin, Kapitall: The Graham Number is a great way to evaluate small-to-middle cap stocks, especially ones that you are concerned might be overvalued. With many analysts now saying the market is a better environment for selling rather than buying, it's getting harder and harder for investors to find a good deal.
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The number itself is calculated by looking at the square root of
Earnings per Share (EPS) multiplied by
Book Value Per Share (BVPS) and 22.5, which is based on Grahams assertion that a Price-to-Earnings ratio should never be above 15 and a Price-to-Book ratio should not be over 1.5.
Book value per share is an important metric to consider when looking at how a stock is performing in a given moment, because it looks at both
inflow (assets coming in, such as retained earnings) and
outflow (dividends and buy-backs). Graham's number attempts to quanitify what a stock is really worth by looking at BVPS alongside numbers that measure a stock's profitability, in light of its price.
many have pointed out that Graham himself advocated using the number as part of a much more rigorous test, which would include looking at a company's debt and long-term performance. While many stocks showed up in a screen we ran for stocks trading below their Graham numbers (174), many of them had taken on far too much debt, or cost too much per share in order to really be considered undervalued.
For instance, the private equity firm
Apollo Global Management (APO), was undervalued by Graham number in our screen and had a huge return on its equity last year (48.20%), but was borrowing tons of money relative to the equity it was bringing in (Long-term Debt to Equity: 12.11). Such a high debt level raises questions as to whether the firm is taking on too much risk in a bullish market. The case of Apollo also illustrates how the Graham number works in different industries. At the moment, private equity firms are likely to see a decline in book value in what they are viewing as
a seller's market.
To make sure that the stocks included in our screen would still hold under most (if not all of Graham's) specifications, we only included stocks with low debt levels, strong sales growth over the last 5 years and P/E ratios below 15. From an initial universe of 174 "undervalued" companies, we were able to narrow down that list to 4.