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Finding Undervalued Stocks 3: Valuing Stocks using Intrinsic Value
In "The Intelligent Investor", Benjamin Graham describes a formula he
used to value stocks. He eschewed the more esoteric calculations and
kept his formula pretty simple. In his words: "Our study of the various
methods has led us to suggest a foreshortened and quite simple formula
for the valuation of growth stocks, which is intended to produce figures fairly
close to those resulting from the more refined mathematical calculations."
The formula as described by Graham, is as follows:
Value = Current (Normal) Earnings x
(8.5 + (2 x Expected Annual Growth Rate)
Where the Expected Annual Growth Rate "should be that expected over
the next seven to ten years."
The value of 8.5 appears to be the P/E ratio of a stock that has zero
growth. It is not clear from the text how Graham arrived at this figure, but it
is likely it represents the y-intercept of a normal distribution of a series of
various P/E values plotted against corresponding growth figures.
Graham's formula takes no account of prevailing interest rates; at the time
he last updated the chapter, around 1971, the yield on AAA Corporate Bonds
was around 4.4%. We can adjust the formula by normalizing it for current
bond yields by multiplying by a factor of 4.40/{Current AAA Corp Bond Yield}.
Bond yields can be found on Yahoo!
Lets take a real-life example, using IBM. According to Yahoo!, the expected
growth rate for IBM over the next 5 years is 10% per annum (note data is
only available for 5 years ahead rather than the 7-10 years Graham states, but
this should not make a significant difference). EPS for IBM over the last 12
months is $4.95. Taking these values and plugging in the 20 year AA Corporate
bond yield of 5.76% (AA Bond
yields are higher than AAA so will give a more
conservative estimate of IV) in our adjustment gives:
Intrinsic Value = 4.95 x (8.5 + (2 x 10) x (4.40/5.76) = $107.77
IBM is currently trading at around $91, so it is currently slightly undervalued.
We can also do the same calculation for IBM's average expected 2005
earnings of $5.62 in order to give some idea of what IBM's price should
be if it meets those earnings estimates:
Intrinsic Value = 5.62 x (8.5 + (2 x 10) x (4.40/5.76) = $122.36
Of course this calculation is somewhat subjective when considered on
its own. It should never be used in isolation - we must always take into
account other factors such as debt/equity, cash flow, management
effectiveness, prevailing economic conditions, etc. Investors should seek
some qualifying criteria such as a PEG (Price Earnings Growth) ratio of
less than 1 in additon to the stock being undervalued based on trailing and
forward intrinsic value. Be aware that PEG itself is also based on future
expectations, so we have to have some degree of certainty that the
company will meet those expectations. We can do this by looking at the
last 5 years growth rate and Earnings figures.
There are, of course, other methods of calculating intrinsic value but
this is certainly one of the simplest.
(c) 2005 The Graham Investor You may use this article, as-is, provided
this copyright notice is kept intact.
About the Author
John B. Keown is an IT specialist, website builder and private investor who enjoys all things stock-related and in particular seeking out undervalued stocks.
He can be contacted via http://www.grahaminvestor.com
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