April 24, 2008
Definition Of Stock Exchange
In “The Intelligent Investor”, Benjamin Graham describes a formula heused to value stocks. He eschewed the more esoteric calculations andkept 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.”
In “The Intelligent Investor”, Benjamin Graham describes a formula heused to value stocks. He eschewed the more esoteric calculations andkept 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 overthe next seven to ten years.”
The value of 8.5 appears to be the P/E ratio of a stock that has zerogrowth. 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 timehe last updated the chapter, around 1971, the yield on AAA Corporate Bondswas around 4.4%. We can adjust the formula by normalizing it for currentbond yields by multiplying by a factor of 4.40/{Current AAA Corp Bond Yield}. Bond yields can be found on Yahoo!
Lets take a real-life example, using IBM. According to Yahoo!, the expectedgrowth rate for IBM over the next 5 years is 10% per annum (note data isonly 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 shouldbe 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 intoaccount other factors such as debt/equity, cash flow, managementeffectiveness, prevailing economic conditions, etc. Investors should seeksome 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 thecompany will meet those expectations. We can do this by looking at thelast 5 years growth rate and Earnings figures.
There are, of course, other methods of calculating intrinsic value butthis is certainly one of the simplest.
(c) 2005 The Graham Investor You may use this article, as-is, provided this copyright notice is kept intact.
ABOUT THE AUTHOR
He can be contacted via http://www.grahaminvestor.com
You need to consider some basics before you enter the world of investing in stocks. The main reason: the stock market is a field dominated by savvy investors, who know the ins and outs of making profitable trades. For people who are not on the inside, Wall Street can be a very dangerous place. Here are a few tips that can help you in your beginning stages:
1) Don’t even consider “tips” that tell you about “hot stocks”. Consider the source: if you had a huge, cannot miss, money making investment tip, would you offer it the world at large, free of charge? You wouldn’t, and neither would anyone else. If someone is touting a can’t miss stock, they most likely have a financial interest in seeing the stock rise. Conversely, if they are rooting for the stock to miss, you can almost rest assured that have “shorted” the issue.
2) Always do your due dilligence. You’ll hear this advice over and over again, and that’s because it’s extremely important and bears repeating. You must always do your own due dilligence. Relying on the advice of others, no matter how well intentioned it may be, is almost always a recipe for disaster. Make sure you dig in and really examine the public numbers and financial releases from companies. Nothing tells the story more clearly than the numbers. Ignore basic touting techniques like press releases which have very little substance, and rely instead on hype to tell the company’s story.
3) Only invest money you can afford to lose. Sure this is a basic point, but tons of people miss it. You should only invest money that you can honestly afford to lose, and without any tears, if the worst case scenario comes to fruition. Everyone enters into investments with the right idea of earning big profits, but in many cases, this never pans out. If you lose your rent money, you can rest assured that your days of dabbling in the stock market will come to a very quick and bitter end. ut asides small amounts of money each week from your paycheck for savings and investment and use that.
The learning curve for investing in stocks can be steep, but in the final analysis is well worth it. In no other endeavor can you make the types of returns that are associated with the world’s greatest stock investors. But make sure to take your time, and keep detailed records of all of your transactions, with particular attention being paid to what you were thinking when you made the trade. Over time, this record will become an invaluable instrument for helping you determine what type of trade makes you the most money, and it will also give you insights into your character as a trader. There’s plenty more to learn, of course, but hopefully these basic ideas will help you on your stock investing journey. Good luck.
About the Author
Darren McLaughlin is the webmaster of the Stock Market Basics resource center.
