Many investors turn to Benjamin Graham's so-called “Graham number” to calculate the fair price of a stock. The Graham number is √(22.5 * 5 year average earnings per share * book value per share), which for American Software gives us a fair price of $5.68. In comparison, the stock’s market price is $11.66 per share. Therefore, American Software’s market price exceeds the upper bound that a prudent investor would pay for its shares by 105.3%.
The Graham number is often used in isolation, but in fact it is only one part of a check list for choosing defensive stocks that he laid out in Chapter 14 of The Intelligent Investor. The analysis requires us to look at the following fundamentals of American Software:
Sales Revenue Should Be No Less Than $500 million
For American Software, average sales revenue over the last 6 years has been $183.33 Million, so in the context of the Graham analysis the stock has low sales revenue. Originally the threshold was $100 million, but since the book was published in the 1970s it's necessary to adjust the figure for inflation.
Current Assets Should Be at Least Twice Current Liabilities
We calculate American Software's current ratio by dividing its total current assets of $156.19 Million by its total current liabilities of $57.49 Million. Current assets refer to company assets that can be transferred into cash within one year, such as accounts receivable, inventory, and liquid financial instruments. Current liabilities, on the other hand, refer to those that will come due within one year. In American Software’s case, current assets outweigh current liabilities by a factor of 2.7.
The Company’s Long-term Debt Should Not Exceed its Net Current Assets
This means that its ratio of debt to net current assets should be 1 or less. Since American Software’s debt ratio is 0.0, the company has too much debt. We calculate American Software’s debt to net current assets ratio by dividing its total long term of debt of $461000 by its current assets minus total liabilities of $59.86 Million.
The Stock Should Have a Positive Level of Retained Earnings Over Several Years
American Software had negative retained earnings in 2020, 2021, and 2022 with an average of $-1625923.076923077. Retained earnings are the sum of the current and previous reporting periods' net asset amounts, minus all dividend payments. It's a similar metric to free cash flow, with the difference that retained earnings are accounted for on an accrual basis.
There Should Be a Record of Uninterrupted Dividend Payments Over the Last 20 Years
Shareholders of American Software have received regular dividends since 2019. The company has returned an average dividend yield of 2.8% over the last five years.
A Minimum Increase of at Least One-third in Earnings per Share (EPS) Over the Past 10 Years
To determine American Software's EPS growth over time, we will average out its EPS for 2010, 2011, and 2012, which were $0.22, $0.11, and $0.10 respectively. This gives us an average of $0.14 for the period of 2010 to 2012. Next, we compare this value with the average EPS reported in 2021, 2022, and 2023, which were $0.24, $0.37, and $0.31, for an average of $0.31. Now we see that American Software's EPS growth was 121.43% during this period, which satisfies Ben Graham's requirement.
It may be trading far above its fair value, but American Software actually does not have the profile of a defensive stock according to Benjamin Graham's criteria because it has:
- low sales revenue
- an excellent current ratio
- too much debt
- negative retained earnings in 2020, 2021, and 2022
- an acceptable record of dividends
- EPS growth in excess of Graham's requirements
