Reflections on the ModernGraham Valuation Formula
Over the summer, I revised the formatting of the presentation of individual company valuations on ModernGraham. As part of that process, I began utilizing 20 years of financial data within the valuations, which allowed me to calculate historical estimates of intrinsic value using the ModernGraham valuation formula. Each valuation thus included a chart showing the price in relation to the MG Value over a period of time. Since then, I’ve been studying those charts in order to determine the effectiveness of the valuation formula. This post will review some of my findings, and introduce a key new metric for ModernGraham advanced premium members to utilize in analyzing investment opportunities.
The Good Parts of the MG Valuation Formula
No matter what, I think there is significant importance in the ModernGraham Valuation Formula and it will always have a place in the ModernGraham approach to investing. This formula comes straight from Benjamin Graham’s classic text The Intelligent Investor, and is as follows:
As I’ve previously stated when comparing the Graham Formula to the Graham Number, Graham intended the Graham Formula to be used as a short-hand method of estimating the intrinsic value of a common stock. He didn’t intend for it to be used exclusively as an evaluation metric, but rather in conjunction with other key factors in an analysis.
In my experience with ModernGraham, the best use of the ModernGraham Formula has been through aggregating the estimated values of the various components of the S&P 500. Each month I do exactly that, reporting the findings in my regular Mr. Market posts. I’ve tracked that data in comparison to the S&P 500’s price level since August 2014 and have been able to find some strong correlations between the Average Price as a Percent of Intrinsic Value in relation to the 12 month return on the S&P 500. In short, the higher the price is in relation to the intrinsic value, the lower the return that was seen over the ensuing 12 months. Here’s a chart showing the findings:
Granted, I only have seven data points to utilize thus far, so we shouldn’t jump to any amazing conclusions, but I do feel that it’s enough data to say that it is certainly worth paying attention to. I’ll be continuing to track this factor to see if the relationship continues over a longer period of time.
The Bad Parts of the MG Valuation Formula
Unfortunately, the results seen in an aggregate of the market are not seen in the short term for individual companies. Rather, it seems that while a company that is trading well below its intrinsic value (in other words, an undervalued company) may see a rise in price over a long period of time, over the short-term the price could rise or fall significantly. For example, take a look at this next chart showing Robert Half International’s (RHI) price in comparison to its value over the last 15 years.
During the period of approximately December 2006 to June 2009 the company would be considered undervalued by the MG Valuation Formula. In contrast, the company would be viewed as overvalued from June 2009 to December 2014. If one had purchased the company in 2007 and utilized a buy and hold strategy over a long period of time, good results would occur. But in the short term, if one had purchased when the company became undervalued in December 2006, the immediate results would not be as strong. The same result is happening in the most recent period of the company being considered undervalued.
Time and time again, I see the same scenario playing out with different companies when I am doing the individual valuations: over a very long period of time it does seem to be better to purchase when a company is undervalued, but over a short period of time anything can happen. Plus, sometimes you have to wait through significant periods of the company being considered overvalued before you see any positive return on the investment.
This seems to highlight a rather significant issue with Graham’s formula, but also highlight’s the importance of the lesson of Graham’s famous Mr. Market parable. If you’re not familiar with that story, the point is essentially that if you know the intrinsic value of a company, you can make rational decisions. Mr. Market, on the other hand, is irrational and may come at you one day with a price considerably below the intrinsic value and come back the next day with a price considerably higher than the intrinsic value. The market is always shifting up and down, while true intrinsic value is much more constant.
Over the last several months, this dilemma has been weighing on my mind as I’ve tried to determine a better way of narrowing down some of the undervalued companies to find the ones that may see faster returns. I’ve toyed with changing some of the inherent calculations such as the determination of the growth rate variable, but the problem is that I don’t want to mess with the ModernGraham Valuation Formula if it has the potential of helping to predict broader market movements. As it stands currently, it could help investors determine how much weight equities should have in a portfolio in comparison to bonds.
Now, I’ve finally come up with an approach that I think is worth pursuing.
Hypothesis & Solution
I’ve often said that the ModernGraham approach is a three-stage method of evaluating investment opportunities. Stage One involves looking at the financial statements to determine if the company is suitable for your investor type. In The Intelligent Investor, Graham provided lists of recommended traits of companies that would be suitable for the Defensive Investor and the Enterprising Investor. I’ve utilized those in developing the Stage One requirements for the ModernGraham approach. Stage Two involves estimating the intrinsic value using the ModernGraham formula. Stage Three is to conduct further research to determine if the company fits the individual investor’s situation.
I’m now proposing that some of the best traits that investors look for when doing Stage Three be moved into Stage Two in order to better evaluate a company. In other words, I think some of the “further research” should be done a little bit earlier in the process. Let’s look at some of the qualities that I’m talking about.
Qualities of Strong Investing Opportunities
Determining a company’s investor type remains a key variable in analyzing a company. Why? Well, for one reason, the entire ModernGraham website is devoted to studying Benjamin Graham’s methods and modernizing them for today’s environment. Graham considered his requirements to be so key to an investor’s research that he devoted multiple chapters of his book to the subject. It would be a disservice to his legacy to move away from that area.
As a result, I believe that whether a company is suitable for the Defensive Investor or the Enterprising Investor should play a significant role in whether a company is considered a good investment opportunity for Intelligent Investors.
Despite some of the drawbacks of the ModernGraham Valuation Formula, one of the key tenets of Graham Investing is to compare the price to the intrinsic value. Further, as I stated earlier, there does seem to be some significant long-term benefits for finding companies when they are undervalued. So, this is another factor that should remain a key consideration when looking at an investment opportunity.
The Graham Number is a common approach used by many investors following Graham’s techniques because it is an easy way to determine if a company meets some of Graham’s most highly regarded requirements for investors. Buying companies that are trading below their Graham Number has been proven to have results that generally beat the indexes. For reference, here is the Graham Number:
Similar to how I’ve been watching my MG Value compared to Price charts for the last several months, I’ve also been watching a chart I provide that shows the Price compared to the Graham Number. Take a look at this next chart (bottom left in the image), which shows the Graham Number and Price of CSX Corporation (CSX) over the last twenty years.
Throughout most of the period, the Price remains above the Graham Number, except for a couple of times. First, somewhere around 2003, next around 2006, and again in 2009. Each of these periods look like they would have been a good time to buy and hold the company. For what it’s worth, the company was considered undervalued throughout that time frame.
However, the Graham Number doesn’t work perfectly by itself. This next chart shows the data for CenturyLink Inc (CTL) over the twenty year period.
Over that time, the price was below the Graham Number at several points and there does not seem to be any predictive value. What’s most interesting is to look at the chart of CenturyLink’s MG Value compared to the Stock Price during some of the same time period:
The company was overvalued most of that time, with the exception of the period of 2008-2010, and I should also note the company is not considered suitable for either the Defensive Investor or the Enterprising Investor. CSX Corporation, on the other hand, is suitable for Defensive Investors. Therefore, an argument could be made that the Graham Number is most effective when utilized as an additional consideration in conjunction with other factors, rather than a sort of “magic” approach.
As a result, it does seem like the Graham Number can be a factor in determining whether the timing of a potential purchase is good, and one of the additional traits that will now be considered in a ModernGraham Valuation is the Graham Number.
Dividend Growth & Yield
Dividends are a key ingredient in any true intelligent investor’s approach to equities. Benjamin Graham put it best by saying that “an investment operation is one which, upon thorough analysis promises safety of principal and an adequate return.” (The Intelligent Investor, Chapter One). One method of providing an adequate return is through the payment of dividends. Dividends provide the investor with a tangible return independent of potential capital returns. In addition, a long-term record of consistent payment of dividends demonstrates a business operation which could provide assurance to the investor of a continued and regular return on the investment.
Dividend growth is another important consideration that has the potential to have a significant impact on an investor who takes a buy and hold approach. For example, using an example from Arbor Investment Planner, consider a company that pays a dividend of $4 per share which grows at a 3% annual rate, and a stock price of $100 per share on day 1 (in other words, a 4% dividend yield at the time of investment). After ten years, that dividend would have grown to $5.22, after twenty years it would have grown to $7.01 per share, and after fifty years, it would grow to a whopping $17.02 per share. That means that if a 22 year old purchased 100 shares at $100 per share for a total investment of $10,000, then at age 72 those 100 shares would be generating $1700 per year in income. And that doesn’t even take into account any growth in the stock price or reinvestment of the dividends paid during those 50 years. If you did take that into account, the total value would be $2,945,703 and the annual income would be $114,357.38!
Therefore, dividend yield as well as a history of dividend growth are two strong factors to consider when looking at investment opportunities.
Using a company’s Price to Earnings (PE) ratio as a valuation metric is a well-known approach with favorable results dating back throughout history. The ModernGraham approach is to utilize normalized earnings as the denominator, thus what I call the PEmg ratio is calculated as the price over normalized earnings. But how does one determine whether a company’s PEmg ratio is low? There are two simple ways: (1) set an arbitrary maximum PEmg ratio when selecting potential companies, and (2) compare the company’s PEmg ratio to its peers.
The first approach is incorporated in the ModernGraham approach through the factors leading to the determination of whether a company is suitable for the two investor types. The Defensive Investor has a maximum level of the PEmg ratio that a company must be below in order to qualify for further consideration. Since the investor type is already listed as one of the qualities here, a maximum PEmg ratio need not be considered as an independent quality.
The second approach, on the other hand, is something I have not incorporated into the ModernGraham approach in the past. The main reason is because I prefer to use a bottom up approach to investing whereby individual companies are compared to other companies regardless of industry. This is in contrast to the top down approach to investing whereby an investment is chosen by first selecting the industry one believes to be undervalued, then a company within the industry. I like a bottom up approach better because it eliminates one speculative factor from the equation. But that’s a discussion for another day.
Going forward, I think it would be useful to put some weight on how a company’s price relates to its earnings when compared to its peers. Such an approach would still support a bottom up stock selection strategy, but add a layer of analysis that may be useful in selecting the top candidates for investment.
Net Current Asset Value
The Net Current Asset Value approach to investing is arguably the most famous of all Graham’s techniques. The Net Current Asset Value is calculated by taking a company’s current assets and subtracting all liabilities, then dividing by the number of outstanding shares. In essence, a company trading below its Net Current Asset Value therefore could be purchased by investors, all liabilities could be paid off with the company’s cash, and there would still be cash leftover to distribute to the investors at a net profit.
Companies that fit this quality are of a special nature and are usually extremely depressed in price. It’s likely that the market has some significant justifications for bringing the price down, but rationally very few, if any, companies should remain in existence if the price is this low. It just would make more sense for investors to take over and liquidate. That said, just like everything else, sometimes the results don’t turn out the way a rational investor would expect. Therefore, this can’t be a singular deciding factor.
New ModernGraham Grading System
So why do I bring all of this up today? It’s because I’ve created a new grading system for looking at companies that incorporates all of the qualities I mention above. This grading system will be based on a traditional U.S. school grade. In other words, the highest grade attainable is an A+ while the lowest grade possible is an F. The weights I apply to each quality may change over time as I continue to tweak things, but in the beginning, the following points will be allocated to a company for meeting each criteria:
|Suitable for Defensive Investor||2|
|Suitable for Enterprising Investor||1.5|
|Undervalued by MG Valuation Formula||1|
|Fairly Valued by MG Valuation Formula||0.5|
|Stock Price Below Graham Number||1|
|20 Years of Consistent Dividend Growth||1|
|Dividend Yield Above 2%||0.5|
|Low PEmg Ratio Compared to Industry Average||0.5|
|Price Below Net Current Asset Value||3|
The company’s grade will be based on the number of points it receives, according to the following table. The maximum number of points a company could theoretically achieve is 9, though a more rational maximum is be 6 (since it is unlikely a company trading below its Net Current Asset Value would also meet every other quality).
So How Does The ModernGraham Universe Look?
Analyzing the 550 companies in the ModernGraham Universe, I’ve found the results to be promising in terms of the system’s ability to narrow down the list. Currently, only two companies receive the A+ grade, with an additional 16 receiving an A. That means that only 3.3% of the companies reviewed by ModernGraham have scored at least a 5 out of 6 points on the scale. I’m happy with that result, and am excited to track the information going forward to see what returns these companies may achieve in comparison to the lower rated ones.
For comparison’s sake, here’s a chart showing the number of companies in each grade.
Where to Find the Grades & New eBook
I expect that if you’re still reading this, you are probably wondering how I plan to distribute this grade information. The short answer is that over the years of operating this site, I’ve found that I have to monetize my work in order to make it worth my time (and believe me, so far I’ve spend a lot more time on this site than the money I’ve generated really justifies). Therefore, a company’s grade will only be provided to premium members.
Advanced-level premium members will be able to see both a static grade at the time of the valuation within each company’s published individual valuation (included in all individual valuations going forward) and an updated grade will be listed for each company in the Enhanced Valuation Spreadsheet published weekly. Basic-level premium members will only see the static grade within the company’s valuation.
In addition, I am planning a new eBook titled “ModernGraham A-Listers” which will be published soon and will take a look at each of the companies receiving an A or an A+ grade. This eBook will be provided free to advanced premium members but will also be available for sale to non-members. Keep an eye out in the coming days for the first issue of the book, and updated issues in the future.
What Do You Think?
Do you like the qualities I’ve selected? Should I add some others, or modify the points given to the different qualities? Leave a comment below to discuss!