Finding Undervalued Stocks 3 – 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 1962, 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/{AAA Corporate Bond Yield}. Bond yields can be found on Yahoo!

Let’s take a real-life example, using IBM. According to Yahoo!, the expected growth rate for IBM over the next 5 years at the time of writing  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.