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 Xylem gives us a fair price of $29.21. In comparison, the stock’s market price is $97.64 per share. Therefore, Xylem’s market price exceeds the upper bound that a prudent investor would pay for its shares by 234.3%.
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 Xylem:
Sales Revenue Should Be No Less Than $500 million
For Xylem, average sales revenue over the last 6 years has been $7.66 Billion, so in the context of the Graham analysis the stock has impressive 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 Xylem's current ratio by dividing its total current assets of $3.01 Billion by its total current liabilities of $1.59 Billion. 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. Xylem’s current assets outweigh its current liabilities by a factor of 1.9 only.
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 Xylem’s debt ratio is -1.3, the company has much more liabilities than current assets. We calculate Xylem’s debt to net current assets ratio by dividing its total long term of debt of $1.88 Billion by its current assets minus total liabilities of $4.45 Billion.
The Stock Should Have a Positive Level of Retained Earnings Over Several Years
Xylem had positive retained earnings from 2010 to 2022 with an average of $1.11 Billion. 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 Xylem have received regular dividends since 2011. The company has returned an average dividend yield of 1.2% over the last five years.
A Minimum Increase of at Least One-third in Earnings per Share (EPS) Over the Past 10 Years
Xylem's earnings per share growth will be calculated using the average EPS of the years 2009, 2010, and 2011, and the average of the years 2020, 2021, and 2022. For the years starting in 2009, we have EPS values of $1.42, $1.78, and $1.50, which give us an average of $1.57. From 2020 to the present, we have EPS values of $1.40, $2.35, and $1.96, which average out to $1.90. The growth rate between the two averages is 21.02%, which falls short of Graham's 30% requirement while remaining positive.
It may be trading far above its fair value, but Xylem actually satisfies some of the criteria Benjamin Graham used for identifying for an undervalued stock because it has:
- impressive sales revenue
- a decent current ratio
- much more liabilities than current assets
- positive retained earnings from 2010 to 2022
- a solid record of dividends
- some EPS growth
