Calculate intrinsic value of any stock

What is stock valuation and why it is necessary?

In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. In the view of fundamental analysis, stock valuation based on fundamentals aims to give an estimate of the intrinsic value of a stock, based on predictions of the future cash flows and profitability of the business. One could say that the intrinsic value of a company is what it is really worth – its real value – while market capitalization is what investors on paper are willing to pay for the business – its price.

The importance of valuing stocks evolves from the fact that the intrinsic value of a stock is not attached to its current price. By knowing a stock’s intrinsic value, an investor may determine whether the stock is over- or under-valued at its current market price. Investing in a company that is overvalued provides a huge downside risk.

How the intrinsic value of a stock is calculated

It is true that technical analysis helps you predict how the stock price is going to move and what price levels it may touch. However, the price is still very closely linked to the intrinsic value of the stock. So, technical analysis only helps determine the direction and the extent of the stock price movement.

Benjamin Graham and Warrant Buffett are widely considered the forefathers of value investing, which is based on the intrinsic valuation method. Graham’s book, The Intelligent Investor, laid the groundwork for Warren Buffett and the entire school of thought on the topic.

Benjamin Graham Intrinsic Value Calculator (Stock Fair Price)

Benjamin Graham’s original Intrinsic Value calculation formula was as following:

V=EPS∗( 8.5+2∗G )

He recognizes different market condition requires a different set of parameters and values. The changes are dynamic so the calculator must be dynamic too. Benjamin Graham’s Intrinsic value formula (revised version):

V=EPS∗(8.5+2∗G)∗4.4:Y

What do the parameters of Graham’s Intrinsic Value formula represent?

EPS (Earning Per Share): You need to enter the EPS value of the trailing twelve months (TTM).

G (Growth Rate): G here means the Growth rate of the EPS. You need to input the estimated average future growth rate of the EPS. This growth rate is not the next year’s growth rate. It is the average of the estimated growth over the next 7-10 years.

2 (Growth Multiplier): Graham used 2 as the growth multiplier based on the median business growth of his time period.

4.4 (AAA Bond Yield till 1962): This parameter represents the AAA Corporate Bond’s Yield till 1962. The average Yield of the USA’s AAA Corporate bond was 4.4%.

8.5 (Fair P/E of Non-Growth Business): This parameter represents the fair Price to Earning (P/E) ratio of a zero growth stock. According to Graham, 8.5 is the fair P/E ratio of a no-growth company.

Y (Current AAA Bond Yield): Y represents the current Yield of AAA Corporate Bond’s Yield. The yield keeps changing, so use the most recent value. This rate can vary a lot based on the country. So, always use the correct countries’ rates. If you don’t use the correct yield then you will be very wrong in your intrinsic value calculation. You can find USA AAA Corporate bonds yields on FRED Website (https://fred.stlouisfed.org/series/AAA).

How to customize the parameters of Benjamin Graham’s Intrinsic Value formula?

In Graham’s revised Intrinsic Value Formula, he used 2 as the growth multiplier. In my opinion, the Growth multiplier should be based on the growth of the business. If you want to be aggressive use a higher value and if you want to be conservative, you should use a lower value for the growth multiplier. For example, for a business that is growing 20-30% per year (i.e. Facebook, Google, Microsoft, etc. ) you should use a lower multiplier than 2.

Graham used P/E=8.5 as the fair value of a non-growth company. Today we have close to zero or even negative rates in some countries. You should use a value range for the P/E of a no-growth business depending on the risk-free interest rate. P/E=8.5 is very aggressive for low-interest conditions. You can use a value between 6.0 – 8.5. Use 6.0 for conservative and 8.5 for aggressive valuation.

Graham’s used 4.4% in his formula because until 1962 the average yield of AAA-rated corporate bonds in the USA was 4.4%. AAA bond’s rate can be very different if you are outside of the USA. In developing countries like Bangladesh or India, AAA bond’s yield could be 7.5 – 8.0% due to their high inflation.

How would I customize Graham’s Intrinsic Value formula for 2021 market conditions?

Based on the 2021 USA market condition, for most of the business/stock, I use the following version of Graham’s Intrinsic value formula:

V=EPS∗( 6.5+1∗G)∗4.4/2.8

Stock’s Fair / Intrinsic value calculation examples using Graham’s formula

Facebook (High Growth) Stock’s Intrinsic value:

I am using Facebook as an example of a high growth company. Let us calculate facebook’s fair value using Grahamäs original intrinsic value formula and my customization. We can compare the results to understand how the market is currently valuing Facebook.

Facebook Stock’s Fundamentals: In 2018 Facebook’s EPS was 7.57 and in 2021(TTM) it is 11.68. The average growth is about 35%. In my opinion, It will be difficult for Facebook to grow at that rate. A growth rate of 25% could be achievable. So, EPS (TTM): 11.68 USD and Future (7-10Y) EPS Growth: 25%.

Facebook’s EPS growth rate is more than 30% thus I used 0.75 as the growth multiplier (Growth Multiplier Value is 1 or less for hight growth company (EPS growth more than 20%)).

Graham’s Intrinsic Value Formula (My Customization) for Facebook:

V=11.68∗(6.5+0.75∗0.25 )∗4.4/2.8=122.7 USD

JnJ (Slow Growth) Stock’s Intrinsic value:

I am using johnson & johnson (JnJ) as an example of a slow-growth company. Let us calculate JnJ’s fair value using Grahamäs original intrinsic value formula and my customization. We can compare the results to understand how the market is currently valuing JnJ.

In 2018 J&J EPS was 5.61 and in 2021(TTM) it is 5.66. The average growth is about 0.1%. In my opinion, JnJ can grow or at least maintain the 0.1% rate. They have more room to grow. I used a 2% growth rate for JnJ because they have pricing power. So, EPS: 5.66 USD and Future (7-10Y) EPS Growth: 2%.

I used 1.5 as the growth multiplier for JnJ because JnJ has stable quality earning, has pricing power and an AAA credit rating.

Graham’s Intrinsic Value Formula (My Customization) for JnJ:

V=11.68∗(6.5+1.5∗0.02 )∗4.4/2.8=119.9 USD

Graham’s Intrinsic value formula is a very good and powerful tool. You must use it carefully and customise the parameters to get more accurate results. Graham’s Intrinsic value method has some limitations: can not calculate intrinsic value if Earnings Per Share (EPS) is negative (you can use the last few year’s mean or median of the EPS if a stock has negative EPS for a year), and do not take the business broader business fundamentals.