Fundamentals and Purpose
The Graham Formula is perhaps the most iconic and accessible valuation tool in value investing. Created by Benjamin Graham, the mentor of Warren Buffett and the "father of value investing," this formula does not seek perfection but protection. Its purpose is to conservatively estimate the intrinsic value of a common stock, serving as a quick filter to identify quality companies trading at significantly low prices.
The underlying philosophy is the Margin of Safety: an investor should only buy when the market price is substantially lower than the estimated value. The formula provides a reference value for that calculation. It is primarily designed for the Defensive Investor, one who prioritizes stability and capital preservation over quick profits.
Components and Calculation Mechanics
The Graham Formula combines two essential metrics of a company's solidity: its ability to generate earnings (EPS) and its book value (BVPS).
The Simplified Formula (Modern Version)
The most widely used version, adjusted for market evolution, is as follows:
Where:
V: The estimated Intrinsic Value of the stock.
EPS: Earnings Per Share of the last twelve months (or the average of the last 5-7 years for greater prudence).
BVPS: Book Value Per Share.
22.5: The Graham multiplier, resulting from a P/E (Price-to-Earnings) ratio of 15 (considered conservative for a no-growth company) multiplied by a P/BV (Price-to-Book Value) ratio of 1.5.
The Logic of the Multiplier
The coefficient 22.5 is a key constraint. Graham insisted that a stock was attractive if its price did not exceed 15 times earnings or 1.5 times book value. Multiplying both limits creates the ceiling of 22.5. A stock meeting both conditions will be the most attractive: P/E ≤ 15 and P/BV ≤ 1.5. The formula combines these two criteria of financial solidity into a single valuation metric.
Practical Application and Use Cases
Using the formula is a three-step process: calculate, compare, and apply the margin of safety.
Use Case: Tangible Asset Companies
Consider the company Solid Manufacturing, with the following data:
Current Price (P): €30
EPS (last 12 months): €2.50
BVPS: €18.00
1. Calculation of Intrinsic Value (V):
2. Application of the Margin of Safety:
Graham suggests buying at 32 of intrinsic value to maximize protection:
Decision: Although the estimated intrinsic value (€31.82) is higher than the market price (€30), it does not meet Graham's strict margin of safety. The investor should wait for the price to fall below €21.22.
Ideal Use Scenario: The Graham Formula shines when evaluating companies with solid balance sheets and tangible assets (banks, insurance companies, utilities, traditional manufacturers), where book value is a reliable measure of the company's assets.
Methodological Criticism and Limitations
Despite its pedigree, the Graham Formula is intensely criticized for its limitations in today's economic context.
Inadequate for Modern Growth
The model is biased against high-growth companies and technology companies. These companies often have low book value (their assets are intangible, like software or intellectual property) and low EPS (because they reinvest all profits). The formula cannot capture the exponential growth potential of a company like Google or Amazon in its early days, making it useless for valuing most modern stocks.
Comparison with Discounted Cash Flow (DCF)
Characteristic |
Graham Formula |
DCF Model |
Complexity |
Low (Quick Filter) |
High (Requires multiple projections) |
Focus |
Past/current solidity (EPS, BVPS) |
Future potential (Cash flows) |
Risk Adjustment |
Implicit in Margin of Safety |
Explicit in Discount Rate (WACC) |
Ideal for |
Stable, mature companies with tangible assets |
Companies with predictable growth, regardless of size |
While DCF is more accurate in projecting future cash flows and discounting them to present value, the Graham Formula is faster and more defensive, relying on past accounting facts.
Frequently Asked Questions and Investor Adjustments
Should I use one-year EPS or an average?
To adhere to Graham's defensive spirit, it is crucial to normalize EPS. Using earnings from a single year can be misleading due to economic cycles or one-off events. The recommendation is to use the average of Earnings Per Share over the last five to seven years.
How do interest rates affect the formula?
Although not explicit in the simplified version, Graham adjusted his reference P/E. In a low-interest-rate environment (as experienced in the last decade), investors justify higher P/E multiples. If rates rise, the opportunity cost of capital increases, and multiples contract. The investor can be more conservative by reducing the multiplier from 22.5 to 20 or even 18 in very high-rate environments.
Can you lose money if you buy below value V?
Yes. Intrinsic value is an estimate, not a guarantee. You can lose money if the company goes bankrupt, earnings drop drastically in the future (even if past EPS was good), or there is accounting fraud. The margin of safety is not insurance but a cushion that reduces the probability of loss but never eliminates it.
The Final Verdict: When to Use It?
The Graham Formula is not the only valuation model and, for many modern cases, not even the best. However, its value as a starting point is immutable.
You should use the Graham Formula if:
You're looking for value picks among boring but stable companies (manufacturing, energy, utilities).
You need a quick screening tool to rule out obviously overvalued stocks by historical standards.
Your main goal is capital preservation and adherence to a strict margin of safety.
It's the discipline, the focus on the balance sheet, and the insistence on paying a ridiculously low price for the company that endures, far more than the exact figure the calculation yields. It is the legacy of the most intelligent investor.
