Ben Graham valuation formula from the 70s.

[scorpioncapital]

In value hunters' compilation of Graham's papers (http://www.rbcpa.com/Common_Sense_Investing_The_Papers_of_Benjamin_Graham_1974.pdf)

 

There are two formulas that peaked my interest.

 

The modified one which can be used in any interest rate environment is

 

IV = earnings/share * (37.5 + (8.8*growth rate / estimated discount rate on 30 year bonds)) * 2/3 (margin of safety).

 

He goes on to say the 2/3 margin is probably a bit too conservative as it tends to bypass a few of the higher quality stocks that never go down as much as peers even in depressions.

 

He also says this excludes credit analysis which you do separately.

 

I've plugged this in on several stocks I like with a 10% assumed growth rate and a 5% rate and still get numbers quite a bit higher than today's market prices - without taking in the 2/3 factor. With the 2/3 factor, the stocks are about 10% overvalued. Without the margin of safety factor they are about 13% undervalued. But some might argue using the 5% discount rate has some margin of safety built in if you don't believe that number will arrive anytime soon.

 

Still...What do people feel about the 5% assumption? It seems unlikely inflation/government debt will get this high in this cycle but is there a possibility of a run-away disaster? It seems the two variables that are highly unknown growth rate and discount rate.

 

Now we know Buffett has said he doesn't worry too much about rates so is he saying to use some higher figure than today whatever you feel is reasonable and forget about spikes above that because the 2/3 margin of safety will offer some protection?

 

 

 

[wachtwoord]

5% discount rate is extremely low to account for the risks of investing in equity.

[Guest Schwab711]

10% growth seems very high in the long-run. Especially at current rates. We'll all be kings in no time :)

[wachtwoord]

10% growth seems very high in the long-run. Especially at current rates. We'll all be kings in no time :)

 

5% is below real inflation.

 

Aldo if you don't aim for at least 10% when investing in equity I doubt you have sufficient margin of safety to account for the risk (with some notable exceptions such as BRK).

[scorpioncapital]

This formula is on a case by case stock basis. I am using it to find Fischer type stocks which by definition are high growers . 10% may even be conservative in this case - think Google 10 years ago.

 

However I get the idea of the equity premium. I'm pretty certain neither Graham nor Buffett used an equity premium, instead they used margin of safety. To me this sounds like the exact same thing. Whether you chop off 2/3 or 50% off your final number or use a 10% equity premium and don't use the margin of safety seems roughly the same. Either way it seems that valuation for a high quality company is neither cheap nor expensive based on this formula today. That isn't to say it's cheap - which GARP and quality stocks rarely are but neither is it a bubble. Probably on the high side with some risks to the growth forecast - and possibly even a risk to the upside on the inflation factor, the question is by how much? One is company dependent (growth) and the other is general environment dependent (inflation rate).