Forgot your password?
New user?
Document Actions
Finding Undervalued Stocks - The Graham's Number Technique
Benjamin Graham (1894-1976) is considered by many to be the architect of Fundamental Analysis and Value Investing. Graham liked to find discrepancies between a stock's price and its value and would buy large portfolios of undervalued stocks, holding them until they became fully valued. In his 1949 book "The Intelligent Investor, Graham describes a stock selection technique that identifies stocks that are trading at a deep discount to a calculated value termed the Net Current Asset Value or NCAV.
Calculation of a
stock's NCAV is a fairly simple endeavor and is somewhat different from the
calculation of Book Value.
Whereas Book Value is purely a per share measure of Assets - Liabilities, the
NCAV is a little more
rigorous. In calculating NCAV, Graham only considered Current Assets, i.e. cash,
cash equivalents, accounts receivable,
inventories. However, from this value he still subtracted Total Liabilities. The result would then be divided by
the number of shares outstanding to give the NCAV per share. This value would be
considered by Graham to be a
fair value for the stock.
You might think he
would buy at this price, but no. In most cases, Graham only bought stocks that were trading
under two-thirds or 66% of their
NCAV.
Consider as an
example G-III Apparel Group Ltd, ticker symbol GIII.
Current Assets are
$130.25M, Total Liabilities are $68.3M, and there are 7.22M shares
outstanding.
NCAV = (130.25 - 68.3) / 7.22 = $8.58. Two-thirds of this
price would be $5.66.
At the time of
writing (03/07/05), GIII is trading at $7.67, so may not be a buy candidate at
present.
It is important to
note that Graham would consider the NCAV to be a first step in further analysis
of the stock. A sensible investor
would investigate the balance sheet further to check for a sound business with
other desirable factors
such as good earnings,revenue growth, low debt-to-equity, and good operational cash
flow per
share.
Stocks trading at
such a deep discount are few and far between, and have usually been beaten down
by a combination of bad
news and
emotional reactions from the investing public. These stocks were Graham's bread and butter. He
repeatedly insisted that the time to buy stocks was when everyone else was
selling and the time to sell was when
everyone else was buying. Had he been alive, he certainly would have been out of
stocks before the dot com bubble
burst and would surely have been picking up bargains soon after. It is no secret
that one of Graham's most famous
disciples is Warren Buffett who has consistently beaten the market by a large
margin with his investments.
One study has
shown that Graham's NCAV strategy works well; in this particular study,
portfolios picked using the
strategy at the beginning of each year between 1970 and 1983 would have returned
an average annual gain of over 29%
when held for only the duration of each year in this 13 year
period.
Van Tharp
mentions an actual investing strategy based on the NCAV or Graham's Number as it
is sometimes called, in his
book "Safe Strategies for Financial Freedom". The strategy as mentioned by
Tharp involves buying stocks
at two-thirds of their NCAV, and selling a third of your holding when a 50%
profit is achieved. If the price continues
upwards to 100% profit, you sell a number of shares to make up half your original holding.
You now have
your original investment back and have a holding of "free" shares. This strategy
can be performed in an IRA using a
large portfolio of perhaps 30 similarly undervalued stocks. If the market has
been declining for several months,
there will be several such stocks to choose from. In an
up trending market, however, it will be much harder to find good
value candidates but diligent investors who do their
homework will more often than not be well rewarded for their efforts.