Published on January 28th, 2015
- The Graham Formula is used to identify under-priced stocks
- See the Top Dividend Aristocrats using the Graham Formula
- Free Excel Spreadsheet download of Graham Formula & Dividend Aristocrats
Benjamin Graham is one of the greatest investors of all time. He was Warren Buffett’s mentor. Benjamin Graham is the founder of Value Investing. He popularized the idea that the market is inefficient, and investors can do well by looking for securities priced below their intrinsic, or fair, value.
Benjamin Graham did much more than theorize about the stock market. His investment fund returned nearly 20% a year over a 20 year period. The stock market returned 12.2% over the same time period.
Benjamin Graham laid out a simple formula to be applied to large, stable stocks to determine if they are undervalued. The Graham Formula is below:
In the formula above, Price is the share price, EPS is earnings per share, and BPS is book value per share.
This article applies the Graham Formula to the 53 constituents in the Dividend Aristocrats Index. The Dividend Aristocrats Index is comprised of businesses that have increased their dividend payments for 25 or more consecutive years.
The constituents of the Dividend Aristocrats Index are generally high quality businesses. Applying the Graham formula to the Dividend Aristocrats Index should find high quality businesses trading at fair or better prices.
Out of 53 Dividend Aristocrats, only 4 pass the Graham Formula. The 4 stocks that pass are:
These stocks all have relatively low P/E ratios and P/B ratios which are the two requirements for passing the Graham Formula. There are an additional 3 stocks that are close to passing the Graham formula. The following 3 stocks would pass the Graham formula if their respective prices fell by 10% or less:
To see additional analysis on the 7 stocks above, click on their names. To download an Excel Spreadsheet of the 53 Dividend Aristocrats and data used to calculate the Graham Formula,Click Here.
The Graham formula quickly indentifies stocks that are likely underpriced. I do not believe it works in reverse; all (or nearly all) stocks that pass the Graham formula are cheap, but not all stocks that fail the Graham formula test are necessarily expensive.
For example, a stock would fail the Graham Ratio if it has small or negative book value per share relative to its price. In Graham’s time, most businesses relied on their assets to generate returns due to the prevalence of manufacturing. Today, money is made through strong brands, new technologies, and services. This is much less capital intensive. As a result, an extremely high P/B ratio (or even negative book value) may not be indicative of being overvalued.
Graham Formula & High Quality Businesses
All 4 of the stocks that pass the Graham formula are in the Top 25 using The 8 Rules of Dividend Investing. Applying the Graham formula to the Dividend Aristocrats Index gives investors an easy tool to identify high quality businesses trading at fair or better prices. I believe the combination is very similar to Warren Buffett’s strategy.
The strategy could be improved upon by removing book value from the equation and looking for stocks that are undervalued based on earnings and/or EBIT, EBITDA, or cash flows. This would help modernize the Graham formula and bring it up to date with changes that have occurred in the economy over the last 60+ years.