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Have you ever worried about overpaying for a stock? Did it keep you from investing in the company? Or did you buy the stock anyways only to get burned in the long run?
Well, I can tell you that I have overpaid to buy stocks – many times in the past. A lot of times actually. Sometimes it worked out. Many other times it did not. I have been burnt more times than I can remember of paying too much to own a stock.
Today, my investment philosophy is much different than it was 15 to 20 years ago. I have shifted my focus to investing in blue chip dividend stocks instead of chasing the next big technology stock.
As part of this shift in philosophy, I don’t worry as much about overpaying for a stock. Investing in blue chip companies removes a lot of the volatility to begin with. Yes, I invest in boring stocks – which means I can sleep at night.
Actually, I can forget about my portfolio for a month (or more) and not worry about it. That is the beauty of investing in boring dividend stocks.
Buying Dividend Stocks On Sale
Even though I like to take a long term investing approach, I still don’t want to overpay to own a stock. There really is no reason to overpay for a blue chip dividend stock.
So how do we know what the fair price is to pay for a company? While there are several different calculations investors can use to find the fair market value of a company, I prefer to use The Graham Number.
I have recently incorporated the Graham Number into my analysis of stocks. Benjamin Graham (who created the formula) used a set of strict rules for screening value stocks. The results of the calculation are what Graham used to set the maximum price one should pay for a share.
What is the Graham Number?
The Graham Number measures the value of a stock based on the company’s earnings per share (EPS) and book value per share. A company with a lower current share price compared to the Graham number may be considered undervalued to some investors. Likewise, those same investors may consider a stock with a share price above the Graham Number as overvalued.
It is one of the many calculations that I use to build the Money Sprout Index. While I don’t calculate this value every month for stocks I own, I think it is helpful to understand where the numbers come from.
How to Calculate the Graham Number
Benjamin Graham was a value investor who believed that one should never overpay for a stock. For example, he believed that investors should not buy a stock with a P/E ratio above 15. He also believed the price to book ratio (P/B) should not be over 1.5.
Based on these two factors, the Graham number calculation (or formula) was created. The formula uses the product of both ratios (15 x 1.5 = 22.5), which allows the P/E or P/B to be a little higher as long as the combination of the two are still below the set threshold.
Based on these criteria, the formula to calculate the Graham Number is –
Fair Market Price = Square Root (22.5 x Book Value Per Share x EPS)
Graham Number Example
Let’s take a look at a familiar example of how the Graham number can be calculated. In a recent article, we provided an example of how to calculate the book value per share of stock for Aflac (AFL).
I have been a AFL shareholder for several years and recently made a lump sum investment in the stock.
In our previous article, the book value per share for Aflac was calculated at $42.30. We will use that calculation in order to find the Graham Number.
- Book Value per Share (BVPS) – $42.30
- Most Recent Earnings Per Share (TTM) – $6.50
AFL Fair Market Price = SQRT (22.5 x $42.30 x $6.50)
At the time of this writing, AFL had a fair market value = $78.65. Since the stock is currently trading around $62 per share, this stock is undervalued and could be considered a “BUY” to value investors.
It is important to point out that these calculations were made at a certain point in time. At the time of this writing, the fair market price for Aflac was much higher than the actual share price. In the future, this may not be the case. If you decide to calculate the Graham Number for any stock, make sure you are using current data.
I have only recently started using The Graham Number in my dividend stock screening criteria. While I find the value can be very helpful for me to find value in the market, I don’t recommend using this calculation to select dividend stocks by itself.
It is important to add in other factors like dividend yield, payout ratio, price to earnings ratio, and dividend growth rate.
For helpful investment tools, please visit the Dividend Stock Resources page here.