The market has been pretty volatile recently, with optimistic buying coupled with fear induced selling. Mr. Market has been highly unpredictable, and it is times like these when value investors sit back and watch the action unfold. Value investors know that the stock prices that Mr. Market quotes them is not the same as the value of those stocks. Ben Graham simplified this concept of price and value by saying, “Price is what you pay; value is what you get.” We can easily figure out the stock price, since it is the cost you incur when you purchase a share of a stock. However, how do you know the value of a stock? Value isn’t something that will just pop up on your screen when you google the stock price of an equity. There are multiple ways to figure out the value of a stock, and each way will get you a different valuation result. In other words, the value that Warren Buffett comes up with is different than what Charlie Munger comes up with. So, finding the value of a stock is an art. Every valuation method has its upsides and downsides, and this is why accounting for a margin of safety is so important for value investors. In this week’s blog post, I will talk about one of the methods that Ben Graham, the father of value investing, used to find the value of stocks. Let’s get straight to it.
Here is the pdf version of Ben Graham Value Formula above. Let us apply this formula to two stocks, Walmart and Apple, and see how their valuations compare to their current stock prices.
Walmart’s trailing twelve months EPS is $4.98. Base PE Ratio is 8.5, growth rate multiplier is 2, estimated earnings growth rate for the next 5 years is 4.73, average yield (AY) is 3.29%, and current yield (CY) is 2.90%. If we plug all these values into the formula, this is what we get:
When we use Ben Graham’s formula, we find the value of a share of Walmart to be $101.50. In order to increase my margin of safety, I personally would decrease this value by at least 25%. So, the conservative estimate of the value of one share of Walmart is $101.50 x 75% = $76.13. In contrast to this value, a share of Walmart is currently trading at $112.99 (08-16-2019). After looking at these two numbers, we can conclude that Walmart’s stock is overvalued.
Apple’s trailing twelve months EPS is $11.78. Base PE Ratio is 8.5, growth rate multiplier is 2, estimated earnings growth rate for the next 5 years is 10.29, average yield (AY) is 3.29%, and current yield (CY) is 2.90%. If we plug all these values into the formula, this is what we get:
When we use Ben Graham’s formula, we find the value of Apple’s share to be $388.63. As you might have noticed, Apple has a high expected growth rate. If Apple doesn’t deliver that growth in the future, our valuation could be completely mispriced. So, in order to increase my margin of safety for this “riskier” growth stock, I personally would decrease this value by at least 45%. So, the conservative estimate of the value of one share of Apple is $388.63 x 55% = $213.75. In contrast to the value, the price of a share of Apple is currently trading at $206.50 (08-16-2019). After looking at these two numbers, we can conclude that Apple’s stock is undervalued.
Please note that Ben Graham’s approach to valuing a company is one of many ways to find value of a stock. A person could use Discounted Cash Flow (DCF) analysis, and come up with a different valuation results than that of Graham’s. There isn’t one valuation method that is perfect. Each method has assumptions that you need to make, but as long as you account for the margin of safety, the valuation thesis should hold in the long run.
Hope you learned a little and found this blog post helpful. We talked about the valuation method used by Ben Graham. We also applied that formula to find the value of Walmart and Apple. As always, you can sign up for our mailing list here. Like us on our Facebook page here. Thank you!
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Superior North LLC’s content is for educational purposes only. The calculators, videos, recommendations, and general investment ideas are not to be actioned with real money. Vyom Joshi is not a professional money manager or a financial advisor. Contact a professional and certified financial advisor before making any financial decisions.