Just about everyone has heard of Warren Buffett, and just about everybody agrees that he is a legend at stock picking. What many people might not know is that much of Buffett’s investing method derived from the work of Benjamin Graham, the author of Security Analysis and the The Intelligent Investor. A veritable renaissance man whose work spanned investing, academia, and even Broadway theater, Graham left an indelible impression on the investing world.
One of his more accessible contributions to investing theory is the “Graham Number” -- not to be confused with his Intrinsic Value formula -- that gives investors a quick way to calculate the fair price of a stock. Microsoft’s Graham number is $69.6, for example. This is the square root of (22.5 x earnings per share x book value per share), and we compare it with the stock’s market price of $242.12. We can see that Microsoft’s market price exceeds the upper bound that a prudent investor should pay for its shares by 247.9%.
Many investor resources mention the Graham number in isolation, but in fact it is only one step in the defensive stock choosing method laid out in Chapter 14 of The Intelligent Investor, which touches on the following points:
Sales revenue should be no less than $100 million. For Microsoft, average sales revenue over the last few years has been $158,804,000,000.00, so according to the analysis the stock has impressive sales revenue. Sales revenue refers to the total income of the company from sales, without taking into account any expenses.
Current assets should be at least twice current liabilities. Microsoft’s current assets outweigh its current liabilities by a factor of 1.8 only. Current assets refer to the company's liquid assets, which are those that can be converted to cash in less than one year, such as accounts receivable, inventory, money market funds, etc. Current liabilities, on the other hand, are liabilities that will come due in one year or less.
The company’s long-term debt should not exceed its net current assets (NCAV). This means that its debt to net current assets ratio should be 1 or less, but not negative. Net current assets being current assets minus total current liabilities. For Microsoft, the debt to NCAV ratio is 0.63.
The stock should have a positive level of retained earnings over several years. In Microsoft’s case, retained earnings have averaged $50,013,000,000 over the last 4 years. Retained earnings is the company's net income available to equity investors after dividends (if any) have been paid out.
There should be a record of uninterrupted dividend payments for 20 years. Microsoft has offered a quarterly dividend since 2004 (18 years), which has returned an average yield of 1.2% over the last five years.
Benjamin Graham wanted to see an increase of at least one-third in per-share earnings (EPS) in the past 10 years. Here, we will calculate the average EPS of the three year "bookends" for the period:
- 2012 EPS: $2.75
- 2013 EPS: $2.00
- 2014 EPS: $1.85
- Bookend 1 average EPS: $2.20
- 2020 EPS: $9.35
- 2021 EPS: $9.58
- 2022 EPS: $9.65
- Bookend 2 average EPS: $9.52
- EPS Growth rate between bookends: 332%
The company has returned fantastic earnings per share growth over the last 10 years. For what it's worth, the company's equity analysts have set a projected short term EPS growth rate of 1.22% for next year.
Microsoft satisfies 5 out of the 7 criteria Benjamin Graham used for identifying a defensive stock with a margin of safety -- even if its stock price is well above its Graham Number. Furthermore, Graham himself warns us in the footnotes of his analysis "that no system or formula will guarantee superior market results. Our requirements 'guarantee' only that the portfolio-buyer is getting his money’s worth."
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