How Graham Number can be used to shortlist undervalued bets

If you have been scouting for long term bets in the on-going rip roaring rally in the equity markets, we have you covered.

Market veterans have formulated many screening methodologies, that can help DIY investors in picking under-valued bets.

In this week’s series, we discuss one such methodology – Graham number coined by Benjamin Graham (regarded as the father of value investing) that helps ascertain the maximum value one can pay for a stock.

Investors can then do further research to fine tune the results of the discussed screening methodology, before boiling down on their investment choice.

The criteria

To arrive at the Graham number, first we start by multiplying the earnings and book value of a company, on a per share basis, with an ideal multiple.

The square root of this product is the Graham number, which is the maximum price one can pay for a stock.

Consequently, if a stock currently trades lower than the Graham number, it is undervalued.

According to Benjamin Graham, the price to earnings multiple and price to book value multiple of a stock should not exceed 15 times and 1.5 times, respectively. However, he believes that a multiplier of earnings below 15 times, could justify a higher multiplier on the company’s assets, or vice-versa.

Net-net, the product of the multipliers should not exceed 22.5 times (15 multiplied by 1.5), which is considered as the ideal multiple for arriving at the Graham number.

But an important point to remember is that the ideal multiplier may not hold good across sectors. Our results reveal higher concentration of capital intensive sectors such as Power Generation and Distribution, Construction, Mining and Gas Distribution, among the undervalued bets, while considering an ideal multiple of 22.5 times.

Besides, the score involves a great deal of recency bias and being heavily reliant on precise data points, ignores one-offs, such as the recent Covid-affected financials of FY21.

The score also does not factor in the continuity of earnings (historical or plausible forecasts), which is an important metric to be gauged while narrowing down on long-term bets. Besides, it is difficult to ascertain the maximum value for companies with either negative earnings or negative book value, using this method.

Hence, looking at the Graham number alone may not be the right way to zero in on your investment choice. However, this screener can sure be a starting point to undertake further research into the businesses we have highlighted below.

Who made the cut

Using the Capitaline database, we filtered undervalued stocks using the Graham number (FY21). Besides, we considered only BSE 500 companies as a starting point to ensure adequate visibility and market interest.

The screener indicates that of the profit making companies (416 companies) within the index, 57 are currently trading below their respective Graham numbers.

Most of these include PSUs such as SAIL, NTPC, Power Grid Corporation, Power Finance Corporation, HUDCO, NMDC, etc.

Prominent names such as Deepak Fertilizers, Wockhardt and Aurobindo Pharma from the currently upbeat chemicals and pharma sectors emerged.

Steel manufacturers, whose share prices soared on the back of the on-going commodity supercycle, also found a place in the list – Welspun Corp, Jindal Steel, Jindal Saw, besides SAIL.

Non-financial metrics

However, do keep in mind that the screener excludes non-financial parameters such as corporate governance, regulatory risks, etc, which have a bearing on the investor sentiment around the stock.

For instance, the short-listed companies include many names from the power generation and distribution sector such as NTPC, Power Grid Corporation, CESC, and NHPC.

Companies in this sector continue to suffer due to lack of a strict tariff policy and delayed payments from discoms.

Investors may need to wait for the abatement of these regulatory overhangs for any value unlocking to kick in.

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