Graham's number

Benjamin Graham was the mentor of Warren Buffett. Besides being the mentor of one of the worlds most successful investor, Benjamin Graham has had a number of interesting ideas and theories. One of these theories is the so-called Grahams number, which is determined by the net current asset value (NCAV). The purpose of Grahams number is to find undervalued shares.

To calculate Graham's number the net current asset value is needed, but also the total liabilities and the number of outstanding shares. The total liabilities are deducted from the NCAV, and what remains is the value which is direct available for shareholders. By dividing this result with the number of outstanding shares, the theoretical value of a share can be calculated. This theoretical value is the risk free value per share when the company is being liquidated. In formula, the calculation is as follows:

A share is undervalued when the price is lower than Grahams number.

Obviously, a degree of undervaluation and overvaluation can be applied. In general, a share is undervalued and buyable when the price is equal or lower than 2/3 of Grahams number.

Not often a share is valued this low, but if a share is valued this low, a nice return can be received. Another advantage of this method of valuation of shares is that the relative expensive, overvalued shares are not purchasable. Obviously, this method should be used consistently, otherwise the risk is run that expensive shares are still purchased.

Focus points Graham's number

There are a number of focus points which should be taken into account when this method is used.

First, this method is based on the current balance of the company. Future gains or losses are not included in the calculation. This means that the validity of the calculation should be assessed on a regular basis. Balance changes should be followed by actions. When the balance changes, a company may be more or less undervalued (or even overvalued). Besides that, the share price can rise above Graham's number so that the company is no longer undervalued.

Second, the cause of the undervaluation is generally a negative sentiment towards the company. Negative announcements are expressed in the share price, dropping the price below the theoretical value calculated with the formula of Graham's number. This means that there must be acted against the general sentiment, which is not always easy. Negative announcements may cause a further dropping of the share price.

The last issue is related to the previous point, namely that this is a long term strategy. There is no guarantee that a share has been bought at the lowest price. The price may still decline even after the share is undervalued. In the longer term, the price will get back to the average valuation and probably the share will even be overvalued. The return on equity which are selected with this method will on long run be above average, higher than the yield of the entire market.

The method of Grahams number sounds logical, but it requires a lot of time to find the right stocks. There are few companies of which all liabilities can be paid off with the current assets and where some capital remains to compensate shareholders. But if time put in selecting the right stocks, a yield can be expected which is higher than the average return on the market.