What Is Graham’s Formula for Intrinsic Value of a Stock?
Benjamin Graham’s formula is one of the simplest ways to estimate a stock’s intrinsic value. It helps investors understand whether a stock is undervalued or overvalued based on its earnings, growth rate, and bond yields. Here’s everything you need to know — explained simply for today’s investor.
Understanding Graham’s Formula
The original Graham formula was introduced by Benjamin Graham, known as the father of value investing and mentor to Warren Buffett. It calculates a company’s fair value based on two main inputs: its current earnings (EPS) and its expected growth rate (g).
- Original Formula: Intrinsic Value = EPS × (8.5 + 2g)
- Revised Formula: Intrinsic Value = (EPS × (8.5 + 2g) × 4.4) ÷ Y
Here, Y represents the current yield on high-quality corporate bonds. The constant 4.4 reflects the average bond yield when Graham formulated his model.
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Breaking Down the Formula
- EPS (Earnings Per Share): Indicates the company’s profit per share over the last 12 months. Higher EPS means stronger profitability.
- 8.5: Represents a fair P/E ratio for a company with no growth.
- g (Growth Rate): Expected annual earnings growth for the next 7–10 years, expressed as a percentage.
- Y (Bond Yield): Current yield on high-quality corporate bonds, which adjusts for interest rate environments.
In essence, the formula rewards higher growth (g) and penalizes high interest rates (Y), making it sensitive to both company fundamentals and macroeconomic factors.
Example Calculation
Let’s assume:
- EPS = ₹50
- g = 10%
- Y = 8%
Using the revised formula:
Intrinsic Value = (50 × (8.5 + 2×10) × 4.4) ÷ 8 = ₹784 per share (approx.)
If the market price is ₹650, the stock may be undervalued; if it’s ₹900, it could be overvalued. This provides a quick screening tool for investors.
Explaining Key Financial Terms
- Intrinsic Value: The theoretical worth of a company based on earnings potential, not market price.
- Margin of Safety: The buffer between a stock’s intrinsic value and its current market price — ensures downside protection.
- P/E Ratio: Price divided by EPS — shows how much investors are paying for each rupee of earnings.
- Growth Rate (g): Expected pace of earnings growth. Higher g increases the intrinsic value, assuming sustainable performance.
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Comparison With Modern Valuation Models
| Model | Inputs Required | Best Use Case |
|---|---|---|
| Graham Formula | EPS, Growth Rate, Bond Yield | Quick valuation screening |
| Discounted Cash Flow (DCF) | Free cash flow, discount rate | Comprehensive valuation |
| Dividend Discount Model (DDM) | Dividend, growth rate | For stable dividend-paying companies |
Advantages and Limitations
- Advantages: Simple, fast, growth-sensitive, adaptable for screening undervalued stocks.
- Limitations: Ignores debt, management quality, cyclicality, and competitive dynamics. Should be complemented by detailed research.
Investor Takeaway
Indian-Share-Tips.com Nifty Expert Gulshan Khera, CFP®, who is also a SEBI Regd Investment Adviser, explains that Graham’s formula remains useful as a first-level screening tool. It should, however, be combined with analysis of debt, competitive strength, and growth sustainability to make actionable investment decisions. Discover more expert guidance at Indian-Share-Tips.com, which is a SEBI Registered Advisory Services.
Related Queries on Stock Valuation
- How to calculate intrinsic value for Indian stocks using Graham’s formula?
- What’s the difference between Graham’s and DCF models?
- When is the margin of safety high enough to buy?
- How does bond yield affect stock valuations?
SEBI Disclaimer: The information provided in this post is for informational purposes only and should not be construed as investment advice. Readers must perform their own due diligence and consult a registered investment advisor before making any investment decisions. The views expressed are general in nature and may not suit individual investment objectives or financial situations.
