Grahams Number: How to Calculate and Use This Classic Metric to Make Yourself a Bundle

by Alex Williams, Managing Editor, Investment U
Wednesday, April 4, 2007: Issue #658

Benjamin Graham isn’t considered one of the greatest investors of all time for no reason

To get an idea of just how good he was, consider this: After the 1929 stock market crash, and during the Great Depression of the 1930s – perhaps the worst bear market ever – Graham averaged returns of 17% a year

And during the last great bear market from 1971-1982, the average annual return on stocks meeting Graham’s “value” criteria was 33.7% a year, according to one study.

So how did one investor not only survive, but prosper handsomely during some of the toughest markets in the American economy?

For Graham, it was one simple number, now known as Graham’s number. And yet today, this one metric is still one of the best ways to determine value.

The fact is, buying companies at deep discounts has made millions for investors who know how to find them before the market realizes what a good deal they are.

Only problem is that really good value analysts are far and few between. Warren Buffett, Legg Mason’s Bill Miller, and Graham are perhaps three of the best.

But we’re going to let you in on a little secret – the famous “Graham’s Number.” He used it to uncover some of his most profitable investments. Today, you’ll see how to use it to uncover some of your own. It takes about three minutes to use

Calculating “Graham’s Number”

Ben Graham, the “father of value investing,” wrote the bible on securities analysis in the 1930s – and it’s the main book on the subject today. He was also Warren Buffett’s mentor, having taught him in college at Columbia University.

So what is Ben Graham’s “Secret Number?” Well, it easily boils down to this: Buy cash at a discount.

Actually, it’s cash and things that can be easily turned into cash.

Graham’s idea is that if you can pay as little as two-thirds of “cash” for a stock, you’ve really got nothing to lose.

Here’s how to get “Graham’s Number” for any company: Current Assets minus Total Debts.

Current assets are defined as anything that can be turned into cash within a year. Total debt is self-explanatory. So another way to describe “Graham’s Number” is a company’s Net Current Assets.

Yet another way to think of it is basically the cash that is left if you were to pay off all debts. And, if you find a company that’s going for two-thirds – or 66% of – the value of its cash, that’s a “value” play.

As you might expect, it’s difficult to find stocks this cheap. To give you an idea of how stringent the criteria are: Out of the thousands of stocks out there, only a tiny handful qualify as good value investments under Graham’s criteria.

Let’s use a hypothetical example, so you’ll see how easy it is to locate a true “value” investment by determining its “Graham’s Number” on your own

Finding A Company’s Net Current Assets

First we need to get the Current Assets and the Total Liabilities of Company XYZ. You can do this in Yahoo! Finance (www.yahoo.com, click on “Finance”). Enter the stock symbol of the company you’re looking for and click on “Balance Sheet,” on the bottom, left-hand-side of the page.

Let’s say the balance sheet for Company XYZ says the following: $3.6 billion Current Assets, and $2.1 billion Total Debt. Therefore, “Graham’s Number” (or net current assets) is $1.5 billion.

Now we need to consider the market value of Company XYZ (also called the “market cap” and calculated as number of shares times current market price). Is XYZ an extraordinary bargain, selling at less than two-thirds of its net current assets?

Let’s say Company XYZ’s market cap is $1.3 billion at the moment. So you can buy the stock for less than its net current assets – you’re buying at a discount to cash, in a sense. A bargain.

However, in order to buy at two-thirds of Graham’s number (1.5 billion, in this case), you’d want XYZ’s market value to be at $1.0 billion or less (66% of 1.5 billion). Cutting to the chase, the current price for XYZ ($6.50, which equates to $1.3 billion in market cap) isn’t at the 66% level we’d need to make this a “Graham’s Number” investment. The price will have to come down to $5 per share for that.

You can do this homework yourself to find stocks that meet this criteria. It will likely take a little wrestling of stock screeners and spreadsheets, or checking out the Value Line. But the hard work can have a significant payoff.

As a matter of fact, here’s a quiz: Is Microsoft (Nasdaq: MSFT) a bargain by Graham’s standards? See today’s Crib Sheet for the answer.

Good Investing,

Alex Williams
Managing Editor, Investment U

Is Microsoft a Bargain?

Based on the company’s most recent quarterly report, here’s how Microsoft’s balance sheet breaks down:

• Total Current Assets $45.2 billion
• Total Liabilities $29.7 billion
• Net Current Assets/”Graham’s Number” $15.5 billion

Right now, Microsoft’s market value (market cap) is $279.5 billion, or 18 times its Net Current Assets. Clearly not a “value” play by Graham’s standards.

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