Benjamin Graham, known as the father of value investment, is famous for his simple, yet powerful, valuation method as first explained in his 1973 book, Intelligent Investor, and later updated in his book entitled Renaissance of Value. His “Graham Number” approach has been adapted and applied to all 30 stocks listed on the Dow Jones Industrial Index to determine which of the stocks have above average safety factors – of which only 10 do. Below is an explaination of the approach, the formula and the results for all 30 stocks. Words: 1220
So conveys Dr. Osman Gulseven in an article* posted on SeekingAlpha.com which Lorimer Wilson, editor of www.munKNEE.com (It’s all about Money!), has further edited ([ ]), abridged (…) and reformatted below for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement. Gulseven goes on to say in the article:
Graham’s initial valuation method was: Long Term Valuation = EPS x (8.5 + 2 x Estimated Earnings Growth) [Go here (1) to see an article on which stocks meet this specific narrow value criteria.]
While the above formula gives practical information on the stock rankings, it does not account for interest rates or inflation. Realizing this limitation Graham later expanded his formula to take into account corporate bond yields as follows: Value = EPS x (8.5 + 2 x Estimated Earnings Growth) x (4.4 / Corporate Bond Yield)[Graham’s approach] is a long-term valuation. It does not imply any target price estimate. Moreover, according to this valuation, companies that are currently loss-making are worth zero. However, the formula can still be used to calculate the margin of safety in the long run as follows: Margin of Safety = (Intrinsic Value – Price) / Valuation with the percentage difference between the valuation price and current price giving us the margin of safety.
Graham suggested choosing the undervalued stocks with the highest margin of safety. Warren Buffett explains the margin of safety as paying $70 for a stock with intrinsic value of $100. Graham is a value investor, and he also suggested choosing dividend stocks with positive earnings, strong balance sheets and reasonable P/E ratios.
Applying the above formulas to Dow Jones stocks gives us the following results.
|Company||Ticker||EPS growth next 5 years||Price||Intrinsic Value||Safety Margin|
|Bank of America||BAC||12.33%||$7.76||-$43.77||N/A|
|Walt Disney Co.||DIS||14.27%||$32.40||$69.93||115.84%|
|The Home Depot||HD||13.18%||$34.00||$62.47||83.73%|
|Johnson & Johnson||JNJ||6.09%||$64.28||$69.15||7.58%|
|Kraft Foods Inc.||KFT||9.32%||$33.95||$37.78||11.28%|
|Merck & Co. Inc.||MRK||4.81%||$31.92||$20.00||-37.33%|
|Procter & Gamble||PG||9.14%||$62.57||$84.20||34.56%|
(Stock market date is derived from Finviz, and corporate bond data is retrieved from the Federal Reserve Bank of St. Louis. EPS growth estimate for Alcoa is derived from Morningstar.)
The current average margin of safety of Dow Jones companies, excluding Bank of America, is 88.01%. Bank of America is the only company in a DJI index that did not report any profits. Caterpillar, Walt Disney, General Electric, Hewlett Packard, Intel, JPMorgan Chase, MMM, Microsoft, Travelers and Exxon have more than 100% margins of safety. Based on the current valuations, and high safety margins, the current snapshot of the market looks promising. If Graham were alive, he could have been on the bullish side of the market.
Both intrinsic value and margin of safety are dynamic concepts. They are highly dependent on analysts’ long-term EPS growth estimates. I used the five-year EPS growth estimates as a proxy for the long-term estimates. Here is a brief summary of those DJI stocks with margins of safety above 100%:
1. Hewlett-Packard is trading with a funky-low P/E ratio of 5.83, a forward P/E ratio of 5.09 [and a Grade “A” O-Metrix Score (see here (2) for full ranking of the Dow 30 constituents in this regard) of 9.13]. It pays a yield of 1.93%. Based on 8.04% EPS growth estimate, the stock offers 237% margin of safety. I think it is one of the cheapest stocks in the market with great bouncing potential.
2. Caterpillar is trading with a P/E ratio of 14.08, a forward P/E ratio of 9.28 [and a Grade “A” O-Metrix Score of 9.91, the highest of any Dow 30 stock]. It pays a yield of 2.16%. Based on 21% EPS growth estimate, the stock offers 187% margin of safety.
3. JPMorgan Chase is trading with a low P/E ratio of 7.74, a forward P/E ratio of 6.48 [and a Grade “A” O-Metrix Score of 8.54]. Yield is 2.76%. Based on 9.39% EPS growth estimate, the stock offers 182% margin of safety.
4. Microsoft, a dividend stock pick for the next FIVE years, is trading with a historical low P/E ratio of 9.35, a forward P/E ratio of 8.07 [but only has a Grade “B” O-Metrix Score of 7.91]. Yield is 2.53%. Based on 11.25% EPS growth estimate, the stock offers 165% margin of safety…
5. Intel Corporation, a dividend stock pick for the next FIVE years, is trading with a P/E ratio of 9.07, a forward P/E ratio of 8.14 [and a Grade “A” O-Metrix Score of 8.68]. Yield is 4.25%. Based on 10.69% EPS growth estimate, the stock offers 164% margin of safety…
6.. General Electric is trading with a P/E ratio of 12.05, a forward P/E ratio of 9.65 [and a Grade “A” O-Metrix Score of 8.12]. It pays a yield of 3.86%. Based on 13.76% EPS growth estimate, the stock offers 139% margin of safety.
7. Travelers is trading 25% lower than its 52-week high, offering a good entry point. It is trading with a P/E ratio of 9.45, a forward P/E ratio of 8.04 [but only has a Grade “B” O-Metrix Score of 6.88]. Yield is 3.40%. Based on 8.64% EPS growth estimate, the stock offers 118% margin of safety.
8. Walt Disney is trading with a P/E ratio of 13.73, a forward P/E ratio of 11.03 [but only has a Grade “B” O-Metrix Score of 6.24]. It pays a yield of 1.23%. Based on 14.27% EPS growth estimate, the stock offers 116% margin of safety.
9. Exxon is trading with a single digit P/E ratio of 9.55, a forward P/E ratio of 8.09 [but only has a Grade “B” O-Metrix Score of 6.13]. Yield is 2.59%. Based on 8.22% EPS growth estimate, the stock offers 109% margin of safety.
10. 3M is trading with a P/E ratio of 13.58, a forward P/E ratio of 11.68 [but only has a Grade “B” O-Metrix Score of 6.18]. Yield is 2.75%. Based on 12.86% EPS growth estimate, the stock offers 101% margin of safety.
Titles and Links to Articles Referenced Above:
Benjamin Graham, the “godfather of value investing” created an equation to calculate the maximum fair value for a stock, referred to as the Graham Number and any stock trading at a significant discount to this number would appear undervalued. [Here are the names of 18 such stocks.] Words: 1707
Jeremy Siegel offered in his book, Stocks for the Long-Run, several actionable techniques that investors might find beneficial, one of which was a 3 parameter approach to stock valuation called the O-Metrix Grading System. The metrix has been applied to all 30 stocks listed on the Dow Jones Industrial Index and 5 stocks top the list. Below is an explaination of the approach, the formula and the results for all 30 stocks. Words: 844
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
- Permission to reprint in whole or in part is gladly granted, provided full credit is given as per paragraph 2 above.