 # How to Calculate the Intrinsic Value of a Company Like Benjamin Graham

Fajasy
Updated: October 25, 2023

### Contents

In this article, I will show you how to calculate the intrinsic value of a company like Benjamin Graham. Graham is widely known as the "father of value investing" and wrote The Intelligent Investor and Security Analysis, two very notable books on value investing. Graham also famously served as a mentor to Warren Buffett, who is currently one of the most successful value investors of all time. Buffett has described Graham's The Intelligent Investor as "by far the best book on investing ever written," which happens to be the book in which Graham's most-recent intrinsic value formula to value growth stocks was published.

Given the reputation and knowledge Graham holds as a value investor and instructor to Buffett, it's logical that value investors learn Graham's valuation method and thoroughly understand the concepts, inputs, and pros/cons that come with the valuation approach. Therefore, this article will show you how to calculate Benjamin Graham's formula for stock valuation by using an example of a publicly traded company (with a free spreadsheet model included). Furthermore, this article will discuss the drawbacks of the valuation method and analyze the viability of using the valuation method across different industries and sectors in the U.S. stock market.

## Benjamin Graham's Stock Valuation Formula

Benjamin Graham's stock valuation formula for growth companies is based on the principle that a stock is a part of a business, and that by analyzing the fundamentals of any company in the stock market, you should be able to derive its intrinsic value independent from its current stock price. Graham suggests that over the long-term, the stock price of a company and its intrinsic/fair value will converge towards each other until the stock price reflects the true value of the company. Finally, Graham recommends that after estimating the intrinsic value of a stock, investors should always purchase the stock with a "margin of safety," to protect oneself from assumptions and potential errors made in the valuation process.

Graham's stock valuation formula to calculate intrinsic value was originally shown in the 1962 edition of Security Analysis as follows:

V = EPS * (8.5 + 2g)

where:

• V = intrinsic value per share (over the next 7-10 years)
• EPS = earnings per share (over the trailing twelve months (TTM))
• 8.5 = price-to-earnings (P/E) base for a no-growth company
• g = reasonably expected annual growth rate (over the next 7-10 years)

In 1974, Graham revised this formula, as published in The Intelligent Investor, to include a discount rate (aka required rate of return). This was after he concluded that the greatest contributing to stock values and prices over the past decade had been due to interest rates.

Graham's current stock valuation formula is shown below:

V = (EPS * (8.5 + 2g) * 4.4) / Y

where:

• V = intrinsic value per share (over the next 7-10 years)
• EPS = earnings per share (over the trailing twelve months (TTM))
• 8.5 = price-to-earnings (P/E) base for a no-growth company
• g = reasonably expected annual growth rate (over the next 7-10 years)
• 4.4 = average yield of AAA Corporate Bonds
• Y = current yield of AAA Corporate Bonds

Note that with Graham's current stock valuation formula, the TTM EPS, growth rate "g," and "Y" inputs regularly change (based on stock prices and new financial data) and affect the intrinsic value per share "V" of any company you're trying to value. Now, let's discuss each of these inputs in Graham's formula (in order) to understand the reasoning behind them, before following an example of a publicly traded company in the stock market.

###### Earnings per Share (EPS)

To begin, the TTM EPS is simply the current normal earnings per share of a business over the last 12 months, and can be calculated as follows:

EPS (TTM) = (Net income - Preferred dividends) / Weighted average shares outstanding

Net income can be found on the most-recent income statement and preferred dividends (if they're being issued) can be found on the most-recent balance sheet. The weighted average shares outstanding can typically be found on the income statement (where EPS is also typically calculated) or in the "Notes to the Financial Statements" section from the most-recent fiscal reports. This EPS calculation is based on the trailing twelve months (TTM), so it should be calculated on a rolling basis (i.e., after every new earnings release).

Investors should realize that this EPS calculation can be manipulated through modern accounting methods (that may inflate/reduce a company's profitability), given that it's calculated from summing net income over the last 12 months. Investors should also recognize that this EPS calculation ignores future/projected earnings. Fortunately, a growth factor is included in Graham's valuation (the "8.5 + 2g") and investors can apply a "margin of safety" (as later discussed) to minimize the potential accounting manipulations made in this intrinsic value calculation.

More sophisticated investors can also choose to calculate the "diluted EPS," which is an adjusted EPS number that attempts to remove earnings fluctuations (e.g., due to seasonality, one-time influences, acquisitions, etc.) and include potential outstanding shares (e.g., from convertible securities, preferred stock, stock options, and warrants).

The diluted EPS formula is shown below:

Diluted EPS (TTM) = (Net income - Preferred dividends) / (Weighted average shares outstanding + Unexercised employee stock options + Convertible preferred stocks + Convertible debt + Warrants)

In short, this EPS calculation approach can provide a more accurate picture of a company's profitability, while also providing a more conservative valuation approach.

###### P/E Base No-Growth Company

The constant "8.5" represents what Graham determined to be the P/E base for a no-growth company. In other words, this is the P/E ratio for a company that will never grow its earnings again in the future.

Although Graham does not teach this, investors can choose to replace this "8.5" constant with a more up-to-date P/E ratio for a no-growth stock. This can potentially better reflect the current market and the stock you're trying to value.

This new value can be derived from the dividend growth formula, as described by Value Tortoise. In short, the P/E ratio for a no-growth company can be calculated as follows:

P/E ratio = 1 / re

where:

• re = cost of equity

Therefore, if the cost of equity for a company was 10%, the no-growth P/E ratio base would be 10x (1 / 10%).

The cost of equity (re) is the rate of return an investor can expect for providing an equity investment into a company. Traditionally, the cost of equity can be calculated by using the "dividend capitalization model" (DCM) if a company pays dividends, or more commonly the "capital asset pricing model" (CAPM). You can use the free calculator below on StableBread to easily calculate this yourself:

###### Growth Multiplier

The constant "2" is simply an arbitrary growth multiplier that was suggested by Graham. This is a quite aggressive growth multiplier as it does not reflect many companies in the stock market today that have annual earnings growth rates of well over 10%, which Graham never really experienced during his time. Therefore, I would recommend that you adjust this growth multiplier down to 1.0 or 1.5.

###### Growth Rate

The growth rate "g" is the rate at which you believe the company will grow at for the next 7-10 years (per annum). This is a prediction of the future, so this growth rate should be based on your understanding of the business before anything else.

If you're less familiar with a company and/or want more supporting data to support your growth assumption(s), you can refer to analyst estimates for future growth or use the 5-10 year historical growth rates for EPS (and extrapolate it into the future). This is an input that significantly influences Graham's intrinsic value calculation, so it's in best practice to be reasonable.

###### Average Yield of AAA Corporate Bonds

The constant "4.4" is the average yield of AAA corporate bonds, which was taken by Graham in 1962 (for 20-year maturity AAA corporate bonds), and is essentially Graham's minimum required rate of return for a stock investment. However old this may be, it's actually a fairly accurate average of the last 10 years (which is ~4%), so I would not adjust this rate unless it's significantly off from the current 10-year average rate for AAA corporate bonds.

You can see a chart of the AAA corporate bond yield below:

###### Current Yield on AAA Corporate Bonds

The current yield on AAA corporate bonds is represented by the constant "Y" in Graham's formula. Clearly, the average yield of AAA bonds changes constantly, and as of writing, is hovering around 4%. The lower this discount rate, the higher the intrinsic value price, and vice versa.

"Y" represents the discount rate for Graham's valuation method. As previously mentioned, Graham observed that interest rate changes were the greatest contributing factor to influencing the overall stock market. As many investors know, this is logical, given that changes in interest rates will always impact bond yields, thus changing the opportunity cost of investing in stocks (over bonds).

The AAA corporate bond yield is used as it represents the near risk-free return you could earn on your money. While U.S. Treasury bonds are essentially risk-free investments (and are frequently used in valuation models as the discount rate), corporate bonds do have a base-level of risk. This is why corporate bonds will always have a higher yield than Treasury bonds. Graham therefore chose to use AAA corporate bonds as the discount rate, as it's the lowest-risk and highest credit rating type of corporate bonds.

### Graham's Formula Example

Now that we understand Graham's formula and its inputs, we can apply the formula to a publicly traded company in the stock market. In this article, we'll use Graham's valuation formula to estimate the intrinsic value of Salesforce (CRM), a massive enterprise cloud computing solutions provider. The company's stock price performance over time is shown in the chart below:

You can use the Google Sheets spreadsheet linked below to follow-along with the example shown here, and the following section on analyzing the Dow Jones Industrial Average (DJIA) stocks using Graham's valuation formula:

Now, I'll find CRM's intrinsic value using just four simple steps, as explained below:

###### Step #1: Find/Calculate EPS

The EPS for Salesforce can be calculated using income statement data from the company's most-recent 10-K annual statement (for FY 2022 in this case):

EPS (TTM) = (\$1.444B - \$0) / 0.974B --> \$1.48

In our case, we're using the TTM EPS calculation, so this results in an TTM EPS of \$1.48.

###### Step #2: Estimate the EPS Growth Rate

The growth rate "g" is the rate at which EPS will grow over time (particularly 7-10 years). Again, this can be determined based on your understanding of the business, past historical growth rates, or by relying on analyst estimates for growth. Yahoo Finance is one popular financial data website where analyst estimates for growth are provided over the next 5 years, as seen below for CRM:

As you can see, analysts estimate the EPS growth rate over the next 5 years (per annum) to be 15.13%. To keep things simple, we can use this growth rate assumption in Graham's CRM valuation model.

###### Step #3: Find the AAA Corporate Bond Yield

As previously discussed, the AAA corporate bond yield represents the discount rate for Graham's valuation method and changes periodically. Again, you can easily locate this data by visiting the FRED website. As of writing, Moody's AAA corporate bond yield is 3.76%, so we'll use this as our discount rate "Y."

###### Step #4: Solve For Graham's Formula

Now that we have all of the required inputs for Graham's valuation formula, all that's left is to solve for intrinsic value. To begin, Graham's revised valuation method to find the intrinsic value of CRM is shown below:

VCRM (revised) = (\$1.48 * (8.5 + 2 * 15.13% * 100)) * 4.4) / 3.76 --> \$67.13

Comparing Graham's intrinsic value calculation to the current stock price of CRM (currently ~\$167) indicates that the stock is not worth buying at its current price, given that the intrinsic value of the stock is less than the current stock price (in this case, about 248% less ((\$167/\$67) - 1)). This also does not take into consideration any margin of safety (as later discussed), so the stock is clearly overvalued from Graham's perspective.

Now, let's solve for Graham's formula again, but this time we'll adjust a few inputs based on the market and our familiarity with the business. Note that the viability and reasoning for adjusting these inputs were discussed earlier in this article.

For our example, I'll change the three following inputs:

• P/E Base No-Growth Company: I calculated the cost of equity (re) for CRM to be 10.64% using the CAPM (re = 2.88% + 1.09*(10% - 2.88%)). This input now becomes 9.4 (1 / 10.64%) instead of 8.5.
• Growth Rate: Instead of using an earnings growth rate from analysts off Yahoo Finance, I calculated the compound annual growth rate for CRM over the 5-year period (2018 - 2022). This growth rate is now 24.74% ((\$1.48 EPS / \$0.49 EPS)(1/5) -1).
• Growth Multiplier: The "2g" is already aggressive, and we're using a strong EPS growth rate of 24.74%, so I brought this down to "1g," which is what most value investors use anyways.

Using these three new inputs, Graham's intrinsic value calculation for CRM is shown below:

VCRM (adjusted) = (\$1.48 * (9.4 + 1 * 24.74% * 100)) * 4.4%) / 3.76% --> \$59.13

Despite making these changes to Graham's valuation inputs, CRM's stock would still appear to be significantly overvalued at its current stock price, even without applying a margin of safety.

## Margin of Safety

"Margin of safety" is defined as the difference between the intrinsic value per share and the current market price of a company. This is a popular investing principle taught by Graham, which states that a security is only worth buying once its market price is substantially less than its estimated intrinsic value price.

Therefore, a margin of safety must be applied to Graham's stock valuation method, given that the intrinsic value per share calculation is not precise (as it's formula-driven and requires assumptions to be calculated). Even if your inputs and assumptions are reasonable, a margin of safety should always be applied. Otherwise, you may end up purchasing a business at an overvalued price, which is never ideal.

The margin of safety percentage you decide on simply depends on your confidence in the valuation, but should generally be on the higher end when lower discount rates are being used (as is the case for AAA corporate bond rates). For Graham's valuation formula, I would never use a margin of safety below 20-30%.

You can apply the margin of safety percentage to the intrinsic value per share of a company to calculate the appropriate buy price using the formula below:

Buy price (BP) = Intrinsic value per share * (1 - Margin of safety %)

As this formula shows, the greater the margin of safety, the more overvalued any particular stock will appear, and the more difficult it will be to find companies trading at your estimated buy price range, and vice versa.

Finally, after the margin of safety is applied to your intrinsic value calculation(s), you can then determine whether the stock is worth purchasing at its current stock price by comparing it to the buy price:

• Buy price > Current market price: Consider buying the stock, as the current market price appears to be undervalued.
• Buy price < Current market price: Consider selling or not buying the stock, as the current market price appears to be overvalued.

Keep in mind that this buy/sell recommendation is purely based on Graham's stock valuation formula and the current market price, and ignores all other fundamental, news, and market factors investors should examine as well before making an investment decision.

###### Salesforce Margin of Safety Example

To assess how a 30% margin of safety would affect CRM's intrinsic value per share calculations, see the two completed examples below for Graham's revised stock valuation method, and the adjusted Graham's stock valuation method I created:

BPCRM (revised) = \$67.13 * (1 - 30%) --> \$46.99

BPCRM (adjusted) = \$59.13 * (1 - 30%) --> \$41.39

Note that "BP" equals the stock's per-share buy price after applying the 30% margin of safety.

## DJIA Benjamin Graham's Stock Valuation Method Analysis

To further analyze Benjamin Graham's stock valuation method for calculating the intrinsic value of a company, I applied the valuation model to all 30 companies in the U.S. Dow Jones Industrial Average (DJIA) Index. This is one of the most popular price-weighted indices and represents 30 large U.S. companies that cover a variety of different industries and sectors (around 25 and 10 respectively). Therefore, examining how Benjamin Graham's revised stock valuation method applies to different areas of the market, albeit, all large-cap stocks, may provide further insight on the best use-cases and limitations of the stock valuation method.

This analysis was completed in May 2022, and all companies that were valued were done so using Graham's most-recent (revised) valuation formula (from The Intelligent Investor):

V = (EPS * (8.5 + 2g) * 4.4) / Y

A default 50% margin of safety was applied to each intrinsic value per share calculation to calculate the buy price (BP) as follows:

BP = V * (1 - 50%)

All other inputs for Graham's stock valuation were kept the same, but the inputs for "g" and "Y" for each company are described below:

• Growth Rate (g): For each Dow 30 company, I calculated the compound annual TTM EPS growth rate over the 5-year period (typically 2017 - 2021). This was accomplished by using the following formula: (EPSfinal / EPSbegin)(1/t) -1).
• AAA Corporate Bond Yield (Y): This is just equal to Moody's AAA corporate bond yield, which as of writing is 3.76%.

Finally, the table below shows my results for each company with its respective sector and industry, the current stock price, buy price, and buy/sell recommendations:

* Based on closing stock price market data on 05/19/2022

If you open the spreadsheet provided before (linked here as well), you can see that this valuation model does not work well for companies with declining or negative EPS growth rates, as the 5-year compound annual growth rate calculation makes EPS growth negative. Although different growth rate approaches can be taken for Graham's valuation method (e.g., a flat growth rate or an average over the 5-10 year period), declining or negative EPS will still cause a negative buy price or error in the valuation model.

## Drawbacks of Benjamin Graham's Stock Valuation Method

Benjamin Graham's stock valuation method was originally derived in 1962 and was revised one last time in 1974. Since then, it has not been touched. It therefore has come with its valid criticisms for estimating the intrinsic value of a publicly traded company. Most of these drawbacks have been discussed in this article already, so these drawbacks will be summarized below:

• Assumptions: Like the discounted cash flow (DCF) valuation method, inputs must be reasonable and relatively conservative. Otherwise, the entire valuation can be incredibly misleading. This can be harder to accomplish for earlier-stage companies and those in particular niche industries/sectors.
• Lack of Business Fundamentals: Graham's valuation approach ignores important business fundamentals such as assets, debt, management, competitive advantages, and more, which heavily influence stock pricing and valuations in the market.
• EPS: The default EPS for Graham's valuation approach is to calculate the TTM EPS, which can be manipulated through modern accounting methods and does not account for future EPS growth. Fortunately, investors can combat against this shortfall in the valuation approach by calculating the diluted EPS instead and/or by applying an appropriate growth rate to the valuation formula (as previously discussed). This valuation approach also does not work well for companies with declining EPS growth rates.
• Growth Default: The growth assumption in Graham's formula (the "8.5 + 2g") is rather arbitrary and is an aggressive measure of the P/E no-growth base of a company and its growth multiplier. Fortunately, investors can calculate the P/E no-growth base of a company by calculating the company's cost of equity (re) and can adjust this growth multiplier to 1.0 or 1.5 to be more conservative, as EPS growth rates are typically much higher today than 50+ years ago.

When discussing the drawbacks of Graham's stock valuation method, it's also important to note Graham's warnings of using his valuation formula, the first being on Graham's original valuation formula (V = EPS * (8.5 + 2g)), although the warning still applies to Graham's revised valuation formula:

"Warning: This material is supplied for illustrative purposes only, and because of the inescapable necessity of security analysis to project the future growth rate for most companies studied. Let the reader not be mislead into thinking that such projections have any high degree of reliability, or, conversely, that future prices can be counted on to behave accordingly as the prophecies are realized, surpassed, or disappointed."

— Benjamin Graham, Chapter 11: Security Analysis for the Lay Investor, The Intelligent Investor.

Graham has also discussed his doubts on using such simplistic formulas for stock valuation, and communicates that his valuation method is limited in its application for stock selection, and that more fundamental, financial data, and other factors must be analyzed before an investment decision is made. Graham also realizes that his stock valuation method is heavily dependent on growth rate assumptions and interest rates.

## The Bottom Line

Benjamin Graham's stock valuation method/formula is a relatively simple approach of estimating the intrinsic value of a publicly traded company. This approach takes into account the interest rate environment while also focusing on the earnings and future growth potential of a business, and as analyzed in this article, is particularly applicable for companies with a positive EPS growth pattern over time. Because this calculation is merely an estimation of intrinsic value, it typically requires a significant margin of safety to protect against assumptions, valuation model shortfalls, and potential errors made in the valuation process.

Graham's valuation formula drawbacks are with the assumptions investors have to make and the lack of business fundamentals the formula assesses, although these are not necessarily "cons" as this is a given for absolute valuation approaches. However, multiple inputs in Graham's valuation formula are outdated and should be adjusted based on your understanding of the company and the market. Even so, Graham's valuation model is still viable for estimating the intrinsic value of a stock, even after 50 years of being published.

In closing, investors can use Graham's valuation formula to reasonably estimate an intrinsic/fair value per share buy price range by adjusting inputs and applying appropriate probabilities (e.g., to the margin of safety, EPS, and growth multipliers/rates). Ultimately, by following Graham's security analysis principles and stock valuation formulas, investors should be able to assess a company's viability and determine an attractive buy price range. Lastly, investors should also learn how Graham's most notable disciple, Warren Buffet, went about improving Graham's approach to valuing companies and estimating the intrinsic value of a publicly traded company in an arguably more accurate fashion.

Disclaimer: Because the information presented here is based on my own personal opinion, knowledge, and experience, it should not be considered professional finance, investment, or tax advice. The ideas and strategies that I provide should never be used without first assessing your own personal/financial situation, or without consulting a financial and/or tax professional.