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TheStreet Open House

The Graham Number: 5 Undervalued Stocks With Huge ROE

James Dennin, Kapitall: The Graham Number is a great tool to find undervalued stocks by comparing earnings to book value. 

One of our favorite data points to use in stock screens is the Graham Number. Benjamin Graham is the grandfather of value investing and Warren Buffet's hero. Expert investors continue to praise Graham's books as some of the best ever written on investing, even though they are more than six decades old. 

Read more from Kapitall: Hedge Funds Are Buying 8 Retail Stocks as Consumer Sentiment Holds Steady

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 Graham's assertion that a price-to-earnings (P/E) ratio should never be above 15 and a price-to-book (P/B) ratio should not be over 1.5.  

Book value per share is an important metric to consider when evaluating stock performance at 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. 

Granted, 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, many of them had taken on far too much debt, or cost too much per share in order to really be considered undervalued.

We started with a universe of around 300 stocks, all of which have exceptionally high  returns on equity  (ROE) ratios of at least 40%. ROE is a good measure of how efficiently a company uses its resources. It should never be looked at alone, however, because executives who want to inflate their company's stock price can borrow money to temporarily bump up the number. 

We then screened that list for stocks that are also trading at a discount to their Graham number. This is not to say that the stocks are certain to recover that value, but it does serve as a reasonable estimate of the upper bounds of a stock's real worth. 

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