Graham Number Introduction — Fair Value Screening

Disclaimer: The Graham Number is a screening tool, not a buy/sell signal. It has limited applicability for growth stocks and banks.

Learning Objectives

After reading this chapter, you will be able to:

• Explain how the Graham Number combines EPS and Book Value — Benjamin Graham's dual-lens valuation
• Apply: Formula uses √22.5 × EPS × BV, where 22.5 = 15 (max P/E) × 1.5 (max P/B)
• Explain how best for manufacturing, metals, PSU, asset-heavy; poor for high-growth IT/SaaS
• Explain how Margin of Safety adds protection beyond Graham threshold alone

Introduction

The Graham Number estimates a fair ceiling for a share based on current earnings + book value. Benjamin Graham, mentor to Warren Buffett, argued that a prudent investor should not pay more than a stock is worth on both an earnings basis and an asset basis.

It is a screening tool — not a buy signal alone. Use it to narrow a watchlist, then verify balance sheet quality, ROCE, debt, and growth before investing.

Core Concepts

Financial Terms

Investment Decision

Proceed to watchlist when:

• ✅ Price < Graham Number
• ✅ ROCE > 15%
• ✅ Debt low
• ✅ Growth positive
• ✅ Sector suitable for Graham (manufacturing, metals, PSU, asset-heavy)

Reject or deep caution when: Graham fails on growth names by design, fundamentals are deteriorating, or leverage is masking weak operations.

Two Companies, Same Price

Company A is cheaper on Graham logic — stronger assets + earnings support.

Formula & Explanation

Earnings Per Share (EPS)

EPS = (Net Profit) ÷ (Total Outstanding Shares)

Example: Profit ₹100 Cr ÷ 10 Cr shares = ₹10 EPS

Book Value per Share

Book Value per Share = (Total Shareholders' Equity) ÷ (Total Shares)

Example: Assets ₹1,000 Cr − Debt ₹500 Cr = ₹500 Cr equity ÷ 10 Cr shares = ₹50

Graham Number

Graham Number = √(22.5 × EPS × Book Value per Share)

Why 22.5? Graham's rule: P/E ≤ 15 and P/B ≤ 1.5 → 15 × 1.5 = 22.5

Worked example: EPS = ₹20, Book Value = ₹100

√(22.5 × 20 × 100) ≈ ₹212

Graham would say: "I would not like to buy this share above ₹212."

Margin of Safety

Margin of Safety = (Graham Number − Market Price) ÷ (Graham Number) × 100

Graham Number ₹200, Market Price ₹140 → MoS = (200−140)/200 = 30%

Visual Guide

Worked Example — Indian Market

Graham Number Walkthrough

EPS ₹20, Book Value ₹100/share:

Graham Number = √(22.5 × 20 × 100) ≈ ₹212

Market price ₹150 → below Graham ceiling → screening candidate (verify ROCE + debt + Altman Z before buying).

Real World Example

Property A: Price ₹1 Cr, annual rent ₹50,000 — expensive relative to income.

Property B: Price ₹50 lakh, annual rent ₹5 lakh — more attractive yield.

Benjamin Graham applied the same logic to shares:

"I do not look at profit alone. I do not look at assets alone. Looking at the two together sets a fair price."

The Graham Number is the combined fair-value ceiling from earnings + book value.

Case Study

Works well (asset-heavy, manufacturing, PSU):

• Maithan Alloys, PFC, REC, Coal India, Nile

Works poorly (growth, low book value):

• IT, SaaS, platform businesses — high growth + low book → Graham often flags as "expensive" despite a legitimate premium.

Gravita (recycling/metals): Graham + ROCE combo is useful for asset-backed names.

Infosys/TCS: Book value relevance is limited — use DCF, P/E vs growth, and return metrics instead.

CFA Exam Tip

The Graham Number does NOT tell you:

• Future of the company, management quality, sector outlook, multibagger potential

It ONLY tells you: "On today's earnings + assets, is the price reasonable?"

Practical Rule — never use Graham alone:

Analyst Conclusion: The biggest gain often comes not from picking the perfect stock, but from avoiding overpaying. Current Price < Graham Number + good growth + low debt = research-worthy candidate.

Common Mistakes

• Graham attractive but Altman Z weak / high debt (value trap)
• Applying Graham to banks/NBFCs/growth IT without adjustment
• Ignoring one-time earnings inflating EPS
• No Margin of Safety despite Graham "pass"
• Asset write-downs making book value unreliable

Key Takeaways

1. Graham Number combines EPS and Book Value — Benjamin Graham's dual-lens valuation.
2. Formula uses √22.5 × EPS × BV, where 22.5 = 15 (max P/E) × 1.5 (max P/B).
3. Best for manufacturing, metals, PSU, asset-heavy; poor for high-growth IT/SaaS.
4. Margin of Safety adds protection beyond Graham threshold alone.
5. Use with ROE, ROCE, debt, and growth — never as a standalone buy signal.

Practice Questions

Chapter: Graham Number | Part 02 | Try before reading answers.

Q1 (Calculate): EPS ₹20, Book Value ₹100 — Graham Number?

Q2 (MoS): Graham ₹200, Market Price ₹140 — Margin of Safety %?

Q3 (Application): Why does Graham fail for high-growth IT names?

Q4 (Red Flag): Price < Graham alone = buy?

Q5 (CFA Style): Graham Number does NOT tell you?

Q6 (Lab): Part 02 Practice Lab Graham screening.

Answer Key

Go deeper: Part 02 Practice Lab

FAQ {#faq}

Q: What should I check after Graham screening?

A: ROCE, debt, Altman Z (for manufacturing), and earnings quality — Graham alone can lead to value traps.

Q: How do I connect theory to Indian market practice?

A: Use Screener/Trendlyne + company annual reports — plot the same metrics over 3 years; paper formulas alone are insufficient.

Q: Graham attractive but Altman Z weak — why avoid?

A: Cheap on price but weak balance sheet = value trap, not value.

Q: One-time earnings inflating EPS — why avoid?

A: Inflated EPS overstates Graham Number and hides true earning power.

Q: How do I drill these concepts in the Practice Lab?

A: Open Part 02 Practice Lab → use the FAQ Drill row for graham-number-intro to practice on real stocks, then verify answers against the Chapter FAQ Quick Index.

Practice Lab FAQ: Full part FAQ index — Part 02 Practice Lab

Related Topics

• Previous Chapter: 10-Balance Sheet Deep Dive
• Next Chapter: 12-Altman Z Score Intro
• Part Overview: Part 02 Financial Statements
• Book Index: Full Table of Contents

Disclaimer: Educational content only. Not investment advice. Consult a qualified financial advisor before investing.