About 1 year ago today, I started to read the Intelligent Investor, which is a book about Warren Buffet and is written by Benjamin Graham, which if you are interested about reading can be found here. One of the biggest things that I retained from this book was the Graham Number. This number helps investors to find properly valued stocks by taking both their Earnings/Share (EPS) and Book Value/Share (BVPS) into account.
This figure is calculated by multiplying a stocks P/E ratio by their P/B ratio. For the stock to be considered “undervalued” this number has to be below 22.5. Furthermore, the P/E value should be under 15 and the P/B value should be under 1.5. With that being said, I will illustrate this with an example using $CO stock (my full analysis can be found here).
As of writing this report $CO has a P/E ratio of 9.77, and a P/B ratio of 1.10. By multiplying these figures together, we get a Graham Number of 10.747 (9.77*1.1). As you can see, this number is below the 22.5 benchmark laid out for a stock to be considered “undervalued”, so I would consider moving forward with an analysis on this stock.
When I look for a stock to analyze I will use Finviz, which is a free online stock screener. I will set the P/E ratio to be 15 or under, and the P/B to be under 1, which guarantees that I will find stocks that are undervalued when comparing them to the Graham Number. Click here to visit Finviz and to have my screener already filled out.
Once I have found a stock that I would like to analyze that fits the criteria outlined in the section above, there are a couple of things that I look for before committing to valuing that stock.
The first thing that I look for is growth in their revenues, EBITDA, EBIT, and decreases in their cost of revenue. If the stocks revenues have been stagnant or declining over the past few years, I look at it as a red flag and tend to stay away from it. What I look for is steady growth primarily in their revenue and EBITDA. If the stock satisfies these requirements, then I will continue.
Secondly, if the stock has passed my first “test” (if you will), I will look at their revenue growth compared to their P/E ratio. Typically, if a company has a P/E ratio of 10, then I will look for revenue growth of approximately 10% YoY. I will continue on with my example of $CO for simplicity.
As we know from the previous section, $CO has a P/E ratio of 9.77, so when I am looking at their revenue growth, I want growth of 9.77% or higher. Anything that is too low (5% in this example) or too high (15%) will be of concern, however the closer we can keep it to the 9.77 level, the better. In this example, $CO's revenues grew at a CAGR of 14.19% over the past 2 years. This is great to see as it is higher than their P/E, but not too high.
This is the last thing that I will look at before fully committing to a full-length analysis on the company.
Firstly, I will select 3 financial ratios, and/or metrics that I will observe and compare to their closest competitors. To get more information on the ratios and multiples that I choose, why I choose them and how to apply them, I would highly recommend you read my other article posted here. (link the article when it becomes available.
I compare these ratios to their competitors, and if their ratios (or multiples) are lower than their competitor's average then I will continue with my analysis on the undervalued stock that I have found.