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Author: hsifyllej Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 18386  
Subject: Re: Ben Graham's Equation Date: 11/1/2001 3:01 AM
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Are you saying that (a) the Graham formula is not, in itself, a substitute for a proper DCF analysis, or (b) it's a tool that is so fundamentally wrong-headed as to be useless for any purpose?

Definitely (a), not quite (b) but almost. The formula is increasing in projected EPS, growth, and decreasing in interest rates like a proper DCF analysis typically is. Therefore, there will be some correlation between Graham's measure and DCA valuations, which may explain your next comment:

I've used it for a few years as a method of getting a first rough cut at stocks that look interesting, and I've had reasonably good results with it -- stocks that look expensive under the Graham formula seem to look expensive when you run the numbers

Unfortunately the functional form is ad hoc and excludes key information on risk and book value making it so imperfect that I'm leaning towards (b) because value investing has to rely on more solid ground.

If your answer is (b), can you suggest a better quick-and-dirty formula for making a first cut?

I don't really perform valuation analyses often. I like residual income based valuation because it's based on raw earnings figures unlike DCF, while being the equivalent of DCF and the dividend-discount model under clean surplus***. Residual income is defined as:
Residual income = current year earnings minus required return times beginning year shareholders equity
If residual income is zero the company didn't create economic value. As required return I could use the CAPM (risk free interest rate plus beta times expected market return in excess of the risk free rate) or something else. The value of a company is then the net present value (computed using a risk-adjusted discount rate equal to the required return) of expected future residual incomes plus current book value. A company that's expected to generate zero future residual incomes, or economic values, should be worth only book value. Empirical research suggests that residual incomes typically are mean reverting towards zero. If residual incomes are expected to be constant over time (more agressive than for the typical firm) firm value is simply:
Value = current book + current residual income / discount rate.
That's my favorite quick-and-dirty formula. Here's an example for Nokia: http://boards.fool.com/Message.asp?mid=15015553. Here's one for LUV: http://boards.fool.com/Message.asp?mid=15196586. To be more precise I need to predict future residual income.

*** Clean surplus means that the change in book value equals earnings minus dividends paid. This is not a bad assumption for most US firms. Berkshire Hathaway is an important example of non clean surplus because, among other things, certain investments (such as KO) are included at market value in book on an annual basis while only appearing in earnings at time of liquidation: http://boards.fool.com/Message.asp?mid=15897935

Datasnooper.
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