What Is Intrinsic Value? – The Ben Graham Formula

My definition of intrinsic value boils down to “a wonderful company fairly valued”. By judging 14 value elements I’ll determine if a company deserves this description.

14 Elements in My Definition of Intrinsic Value
(1) Strong Cash Flow
(2) Strong Earnings Growth
(3) Dividend Consistency
(4) Consistent Dividend Increases
(5) Profitability
(6) The Formula: E(2R+8.5)*Y/4 = Intrinsic Value per share
(7) Good returns on equity(8) Little or no debt
(9) A business model I understand
(10) A durable competitive advantage
(11) Measure Risk
(12) Providing reliable long term dividend income streams
(13) Increasing annual dividends faster than the inflation rate
(14) Expect to generate at least a 9% total return compounded annually

(6) The Formula: E(2R+8.5)*Y/4 = Intrinsic Value per share
Benjamin Graham offered this formula for intrinsic value in his book for individual investors, The Intelligent Investor: The Classic Text on Value Investing.

The three formula parameters are:
E – Current earnings per share
R - The expected earnings growth rate
Y - The current yield on AAA rated corporate bonds

Benjamin Graham’s definition of intrinsic value is not mine. I’m not really a “value investor” in the pure sense – perhaps not in any sense. I’m not trying to buy deeply discounted stocks with the intention of selling them when they rise to their intrinsic value. My intention is to buy growing companies that pay growing dividends and to hold them for as long as they continue doing both.

Of course, I’ll be happy to buy them at a deep discount but that’s not the reason Ben Graham’s formula is one of my value elements. I’m willing to pay fair value for a stock that’s likely to meet my financial objectives - but I want to avoid paying too much.

So, I’ll calculate Benjamin Graham’s intrinsic value (GIV) and compare it to the current stock price. If the stock price is less than the GIV it’ll pass my filter. If it also passes Graham’s 20% margin of safety rule I’ll give it extra credit.

I need the values of his three parameters in order to calculate GIV. Here’s how I’ll get them.

E – Current earnings per share
I’m already picking up the earnings per share (EPS) as part of value element (1) Strong Cash Flow so I’ll simply use that value for E.

R - The expected earnings growth rate
I calculate an historical earnings growth ratio as part of element (2) Strong Earnings Growth. I’ll use that value for R.

Y - The current yield on AAA rated corporate bonds
I’ve not been interested in the yield on AAA corporate bonds so far. Fortunately, this parameter isn’t dependent on each company’s performance. I can check it periodically and use the value in all of the GIV calculations.

I’ve found a reasonable source for this figure at the Yahoo! Finance Bond Center. The average yield for ten year AAA rated corporate bonds on April 7th, 2010 was 3.78%. This will be my value for Y. I’ll refresh the parameter at least monthly.

With the parameters defined and sourced I can simply plug them into the Benjamin Graham GIV formula recreated in an Excel workbook and calculate GIV for each stock I analyze.

With this I’ve defined exactly half of my fourteen value elements. Some of the rest will be harder I think.

Link to Other Topics in the Get Rich Slowly Report: What Is Intrinsic Value?