What is the Graham Number?
The Graham number (or Benjamin Graham’s number) is a simple valuation rule-of-thumb that estimates the maximum price a defensive value investor should pay for a share of stock. It combines a company’s earnings power and balance-sheet backing into a single ceiling price. If the market price is below the Graham number, the stock may be considered undervalued; if above it, it may be overvalued for a defensive investor.
Fast fact
The constant 22.5 used in the formula equals 15 × 1.5 — the P/E ceiling (15) and the P/B ceiling (1.5) Benjamin Graham suggested for a defensive purchase (so the product of P/E × P/B should not exceed 22.5).
Formula and calculation
Graham number = sqrt(22.5 × EPS × BVPS)
Where:
– EPS = earnings per share (Graham recommended using normalized/average earnings)
– BVPS = book value per share (last reported book value per share)
– sqrt denotes the square root
Example
If EPS = $1.50 and BVPS = $10.00:
Graham number = sqrt(22.5 × 1.5 × 10) = sqrt(337.5) ≈ $18.37
Interpretation: A defensive investor would consider $18.37 the maximum pay price. A market price of $16 would look attractive; $19 would be above Graham’s suggested ceiling.
Who was Benjamin Graham?
Benjamin Graham (1894–1976) is widely regarded as the father of value investing. His books The Intelligent Investor and Security Analysis laid the foundations for buying securities for less than their intrinsic value. Warren Buffett was a student of Graham and later credited him as a major influence.
How the Graham Number works in value investing
– It enforces a conservative valuation ceiling based on both earnings (income statement) and book value (balance sheet).
– It’s designed for “defensive” investors seeking safety and simplicity, not for growth investors.
– It normalizes company metrics against Graham’s suggested limits (P/E ≤ 15 and P/B ≤ 1.5) so investors can quickly screen for potentially undervalued stocks.
What is a “good” Graham number?
– The Graham number itself is not “good” or “bad” — it’s a calculated ceiling. What matters is how the current market price compares to it.
– General heuristics (not hard rules):
– Market price Graham number → not attractive for a defensive Graham-style buy.
– Use these thresholds as starting points, not as final buy/sell rules.
Limitations and caveats
– Not suitable when EPS ≤ 0 or BVPS ≤ 0 — formula becomes meaningless with negative earnings or negative book value.
– Ignores growth prospects: fast-growing companies often deserve higher P/E and P/B ratios.
– Accounting sensitivity: different accounting methods, write-downs, or one-time gains/losses can distort EPS and BVPS.
– Intangibles and off-balance-sheet items: firms with large intangible assets (brands, IP) or leases might have understated book values.
– Industry differences: financial firms, banks, cyclical industries, or early-stage companies require tailored metrics.
– Management quality, competitive position, industry trends, capital allocation, and cash flow health are not captured.
Practical steps: how to use the Graham Number (step-by-step)
1. Gather inputs
– EPS: Prefer a normalized or averaged figure (Graham recommended average earnings over the prior 3 years). You can use trailing‑12‑month (TTM) EPS or a 3-year average to smooth volatility.
– BVPS: Use the most recent reported book value per share from the balance sheet (shareholders’ equity ÷ shares outstanding). Consider using tangible book value (book value − goodwill − other intangibles) for firms with large intangibles.
2. Adjust inputs (recommended)
– Remove one‑time items and extraordinary gains/losses from EPS to get normalized earnings.
– If the company has significant preferred stock or minority interests, adjust shareholders’ equity accordingly.
– For cyclical firms, use multi-year averages; for banks, examine regulatory capital metrics as well.
3. Calculate the Graham number
– Graham number = sqrt(22.5 × EPS × BVPS)
– Example: EPS = $1.50, BVPS = $10 → Gn ≈ $18.37
4. Compare to market price
– Compute Price / Graham number (or % difference).
– If Price Graham number → not attractive under Graham’s defensive limits.
5. Run additional checks (essential)
– Look at cash flow (free cash flow yield), debt levels (debt/equity, interest coverage), ROE, margins, and revenue trends.
– Qualitative checks: competitive moat, management quality, industry dynamics.
– Apply a margin of safety: require a discount below the Graham number (e.g., 20–30%) before committing capital.
6. Decide and monitor
– If you buy, track earnings trends, book value changes, and any structural changes to the business.
– Recalculate Graham number periodically as EPS and BVPS change.
Practical screening workflow (example)
– Filter for EPS > 0 and BVPS > 0.
– Compute Graham number for each candidate.
– Find stocks where market price ≤ Graham number (or ≤ 0.8 × Graham number for a stronger margin).
– Narrow by industry, leverage limits, cash flow, and qualitative criteria.
– Perform a deeper fundamental analysis before any buy decision.
Explain Like I’m Five
Think of a company like a house: earnings are the rent it collects, and book value is the structure and stuff inside. The Graham number gives a simple “maximum safe price” by combining a measure of the rent and the house’s value. If the asking price is lower than that number, it could be a bargain — but you still should check the roof, neighborhood, and whether the rent will keep coming.
When not to use the Graham Number
– Startups or high-growth companies where earnings are negative but future earnings expected.
– Financial firms where book value and regulatory capital nuance interpretation.
– Companies with heavily inflated goodwill/intangible assets unless you adjust to tangible book value.
– Extremely cyclical industries without normalized earnings.
Related metrics and complementary checks
– Price/Earnings, Price/Book, Price/Cash Flow, Free Cash Flow Yield
– Discounted Cash Flow (DCF) for companies with predictable cash flows
– Return on Equity (ROE), Debt/Equity, current ratio, interest coverage
– Qualitative factors: management, moat, industry structure
Sources and further reading
– Investopedia, “Graham Number” (Theresa Chiechi). https://www.investopedia.com/terms/g/graham-number.asp
– Benjamin Graham, The Intelligent Investor (Revised Edition), Harper Business. (See discussion of the 15× P/E and 1.5× P/B limits and Graham’s “defensive” criteria.)
Bottom line
The Graham number is a useful, conservative screening tool that combines earnings and book value to create a simple maximum-price guideline for defensive value investors. It’s quick and universal, but it’s only a starting point. Use it alongside normalized accounting inputs, a margin-of-safety buffer, and further fundamental and qualitative analysis before making investment decisions.