Financial Jargon

What is the Graham Number and Why it Still Matters

2016, Financial Jargon / Steve

The Graham Number is a calculation used to see if a stock is trading at its fair value. It’s named after the father of value investing Benjamin Graham.

Graham Number

Graham, known as the “Dean of Wall Street”, began teaching value investing at Columbia Business School in 1928. Together with David Dodd, they wrote their famous book Security Analysis in 1934, following the largest stock market crash in history.

Graham is arguably more known as the mentor to Warren Buffett.

Warren Buffett

After the Great Depression, many people were trying to make sense of why the market imploded. Benjamin Graham is rightly attributed to making sense of the market. He looked at the underlying value of a company instead of the stockpickers go-to method, which at the time was “earning trends.”

The Graham Number

To find the fair value of a company, Benjamin Graham came up with a formula that could be applied to any security. He wrote this formula in chapter 14 of The Intelligent Investor.

Or 22.5 times Earnings per share times Book Value per share =X

Now find the square root of X=Y

Y will be the Graham number

The Graham number will be the intrinsic value, or in other words, what a company is actually worth. If the Graham number is above the current market price of a company, it could be trading at an undervalued price!

An Example of the Graham Number

I’ll use Walmart for an example.

The current share price is $69.60.

To find out the Graham Number we need to find out it’s most recent earning per share and it’s book value per share. Then find the square root of that number.

It’s trailing 12 months (most recent) EPS = $4.64

It’s current BPS =$24.74

22.5 x 4.64 x 24.74 = 2582.85

√2582.85 = 50.82

Using this formula we come to the Graham Number or the intrinsic value of Walmart – $50.82

So it would appear that the market is overvaluing Walmart right now at the going price of $69.60 vs the Graham value at $50.82

Is it still Relevant?

Warren Buffett learned from Ben Graham

Many people still buy Wal-Mart at today’s price even though it is overvalued according to the Graham Number. The reason for this could be many, but the main reason is because people still believe the company has further room to grow.

You will often here of Growth vs Value. You might never see Google or Apple hit a good Graham Number and they might still have a long way to grow, but there always is an end to how far a company can grow.

If you look at Warren Buffett’s portfolio, the world’s greatest investor, nearly 25% of the companies he owns pass the Graham Number test. Many of the rest are close. Clearly he still thinks that the formula has value.

Warren Buffett has 4 favorite books. Ben Graham wrote 2 of them. Security Analysis and The Intelligent Investor.

In writing the foreword to Security Analysis, when describing his tutelage at Columbia University under Benjamin Graham he wrote:

“what I learned then became the bedrock upon which all of my investment and business decisions have been built”.

What is the Graham Number and Why it Still Matters Read More »

Payout Ratio

Financial Jargon / Steve

What is it?

The payout ratio, or dividend payout ratio, is how much money the company earns (EPS) compared to what it is actually paying out to its shareholders in dividends (DPS), typically expressed as a percentage.

As a formula it looks like this:

For any dividend investor this is perhaps one of the most important metrics but probably the least used in practice.

The reason the Payout Ratio is important is because it give you the clearest indicator if the potential for a dividend cut is coming. If a company is paying out more in dividends then it earns the Payout Ratio will tell you all about it.

How does it work?

DIVI-CENTS CORP has an earnings per share of $1 and dividends payout of $0.70 per share. This shows it has a Payout Ratio of 70%. Not Bad. Now lets look at the competition.
DIVI-MART INC has an earnings per share of $2 and dividends of $2.55 per share. The Payout Ratio is 125%. Not too good!

Which company has the more sustainable dividend payout?

In some cases, a payout ratio can exceed 100 per cent.

Why should you care?

Depending on DIVI-MART INC balance sheet, it could possibly dip into it cash reserves or borrow depending on it’s credit, to keep the dividend going. The problem is a company can’t pay out more than 100% forever. Sooner or later it will be forced to do one of two things.

Hope they can earn more money in the near future to cover dividend or
Cut the dividend to a sustainable level

More often than not a company will cut it’s dividend.

As a dividend investor, this is the worst case scenario. When a company cuts it’s dividend, it’s usually a sign of distress and can cause a chain reaction.

Typically, when this happens, investors flee, causing the share price to drop so that the investor who stays ends up with a company worth less as well as a reduced dividend payment.

When you notice some holes in the ship, it’s better to flee and get your toes wet then to be stuck on board when it goes down and realize, there is no life vest.

A good read in this link. Oil investors see $7.4-billion vanish as dividends targeted

What is a Yield?

Financial Jargon / Steve

Now that we have an understanding of what a dividend is lets look into the yield.

A yield is the dividend per share divided by the current price of the stock expressed as a percentage.

Yeild paint

Here’s an example.

Say you own shares of DIVICENTS CORP! and they pay out a yearly dividend of $1 per year. The current price is $10.

1÷10=0.1 or 10%

This would give D.C! a current yield of 10%.

Now, as I mentioned above, a yield is the dividend per share divided by the current price of the stock, what we have to keep in mind is that the price of a stock is almost always in motion. Say that our shares of D.C! had a great year and have moved all the way up from $10 a share up to $20. Although the shares have double D.C! board of directors have decided to keep the dividend payout at a steady $1 per year.

Now lets look at the yield again. $1 divided by $20 current share price is 1÷20=0.05 or 5%. The dividend stayed the same yet the yield was cut in half.

Having a low yield is not necessarily a bad thing, nor having a high yield is necessarily a good thing. Let’s have a look at a couple scenarios.

Let’s pretend D.C! just released a press statement saying that they have won an exclusive contract to supply all the ingredients to make soap to the PAPER STREET SOAP company. paper-street-bar-soap-fight-club

PAPERSTREET SOAP is the biggest and best soap company in the world and D.C.! is going to make a lot of money of this deal. This is a tremendous opportunity and D.C! stock just went through the roof. It’s stock is now trading at $40 per share. It’s still 2 months away from releasing it quarterly financial results so the dividend are staying at $1 until then with no guarantee of them going up. The current yield is $1÷$40=0.025 or 2.5%. Not a great yield but I would still think this is a buying opportunity with a high probability that the EARNINGS PER SHARE or EPS will increase in the next quarterly result and D.C! will increase their dividend payout!

Now scenario 2. Let’s pretend that DIVICENTS CORP! has been supplying PAPER STREET SOAP company with all it soap making material exclusively for the past 2 years. D.C! has increased its dividend every quarter for 2 years and is now paying out a pretty hefty dividend of $3 per share. Out of no where PAPER STREET SOAP company releases a press statement that they are terminating their exclusive deal with D.C! due to the fact that D.C! wasn’t selling them tallow as they had promised but instead had been supplying human fat from a Liposuction clinic! The news wreaks havoc and the shares of D.C. crash all the way down from $40 to $20. It’s still 2 months away from releasing its quarterly financial results and the dividend is still $3 but everyone on the street knows D.C. EPS are going to take a massive hit. The current yield is now sitting at $3÷$20=0.15 or a massive 15%. Although this is seemingly a fantastic yield I would not judge this to be a good buying opportunity until we have some clarity on the earnings. Seeing a 15% yield would definitely send up the red flag and could possibly result in a cut to the dividend.

HIS DIVIDENDS JUST GOT CUT!

A company needs to make enough money to payout the dividend!!

To understand if the dividend is in risk we have to learn about a couple more things. Earnings per share or EPS and Payout ratio.

WHAT IS EARNINGS PER SHARE?

WHAT IS A PAYOUT RATIO?

What is a Yield? Read More »