In The Intelligent Investor, Graham laid out an equation that was designed to help people value a growth company. The equation goes like this:
P = ProjEPS * (8.5 + (2*G)) * (4.4/AAA yield)
Looks scary, but it's not. Let me break it down for you.
= the price of the company's stock. This is what the equation will tell you.
= the projected earnings per share. You're looking for next year's estimated earnings per share. (Get estimates here.)
Graham surmised that a zero growth stock should have a P/E multiple of 8.5. This reflects an average return of 12% per year. For what it's worth, I think this is a little shaky given the wide variety of circumstances leading to a company with zero growth. As you'll see, Graham put some qualifiers on this equation.
where G is the long-term projected growth rate of a company's EPS. Graham said that you should be comfortable that the company will grow its earnings at this rate over the next seven to 10 years.
Unfortunately, most companies/analysts only give 5-year expected growth rates, so you'll have to use those.
This was Graham's benchmark for a required rate of return to invest, period. He surmised that at a minimum, an investor needed to be compensated for the effects of inflation and a small risk premium above that. You might be tempted to "play around" with the 4.4, but I keep it constant.
This is the yield on the AAA corporate bonds. I like to use the 30-year composite yields, but they are difficult to find. Here is a link that's a few weeks dated, but it'll serve for now: http://www.bondresources.com/Corporate/Rates/AAA
The 30-year yield on AAA corporates is about 6.25%.
Okay, so what does all this mean and why am I bothering you with it? Last week, I wrote about risk and expected returns. If you remember, we talked about how investing in one asset class (stocks vs. bonds vs. CDs, etc.) requires that you receive a greater rate of return relative to less risky classes. Graham's equation builds in an equity growth premium as well as an interest rate factor. It's not a magic formula that will solve all of your problems, but it does provide a decent data point to consider in our evaluation of a company's stock price.
Let's quickly do an example using Pfizer:
P = 1.59 * (8.5 + (2 * 19.5)) * (4.4/6.25)
P = 1.59 * (8.5 + (39)) * (.704)
P = 1.59 * 47.5 * .704
P = $53.16
According to this simple equation, Pfizer's value is about $53. The stock currently trades around $42.50. If you were to take this as gospel (and you better not), you might conclude that the stock is about 25% undervalued at current prices.
Why am I so cautious and advising you against using this as your "magic dust"? Well, it's only one model, it's imperfect, and it doesn't account for a host of other issues a company may deal with. It also doesn't address other kinds of valuations, such as discounted cash flow analysis, among others
Graham provided four major caveats to his equation that I should share here.
In the book Small Stocks, Big Profits, Dr. Gerald Perritt describes these caveats as follows. In screening stocks, you should:
Eliminate all firms with negative earnings (losses).
Eliminate all firms with debt to total asset ratios greater than 0.60 (i.e., firms with total debt greater than 60% of total assets).
Eliminate all firms with share prices above net working capital per share.
Eliminate all firms with E/P (earnings divided by price) that are less than twice the AAA bond yield.