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 Eaton gives us a fair price of $76.72. In comparison, the stock’s market price is $220.44 per share. Therefore, Eaton’s market price exceeds the upper bound that a prudent investor would pay for its shares by 187.3%.
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 Eaton:
Sales Revenue Should Be No Less Than $500 million
For Eaton, average sales revenue over the last 6 years has been $34.47 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 Eaton's current ratio by dividing its total current assets of $8.75 Billion by its total current liabilities of $6.36 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. Eaton’s current assets outweigh its current liabilities by a factor of 1.4 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 Eaton’s debt ratio is -0.9, the company has much more liabilities than current assets. We calculate Eaton’s debt to net current assets ratio by dividing its total long term of debt of $8.32 Billion by its current assets minus total liabilities of $17.94 Billion.
The Stock Should Have a Positive Level of Retained Earnings Over Several Years
Eaton had positive retained earnings from 2011 to 2022 with an average of $7.3 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
Eaton has offered a regular dividend since at least 2011. The company has returned an average dividend yield of 2.6% 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 Eaton's EPS growth over time, we will average out its EPS for 2010, 2011, and 2012, which were $2.73, $3.93, and $3.46 respectively. This gives us an average of $3.37 for the period of 2010 to 2012. Next, we compare this value with the average EPS reported in 2020, 2021, and 2022, which were $3.49, $5.34, and $6.14, for an average of $4.99. Now we see that Eaton's EPS growth was 48.07% during this period, which satisfies Ben Graham's requirement.
It may be trading far above its fair value, but Eaton actually meets most of Benjamin Graham's criteria for an undervalued stock because it has:
- impressive sales revenue
- just enough current assets to cover current liabilities
- much more liabilities than current assets
- positive retained earnings from 2011 to 2022
- a solid record of dividends
- EPS growth in excess of Graham's requirements