The Graham Model is an investment approach that is commonly used today by individual investors and portfolio managers. The approach was originally formulated over 60 years ago with the publishing of Graham and Dodd’s college textbook “Security Analysis.” The valuation model employed by Graham provides a method of determining buying and selling points in a company’s stock through the determination of a central value as well as an upper and lower valuation range based on historical interest rate and fundamental data.
Publication Length (Number of Pages)
- Dow Jones Industrial Average (38 pages)
- S&P/TSX 60 (68 pages)
- S&P 500 (518 pages)
Graham estimated the central value, or fair value, of a stock by capitalizing the average earnings per share over the previous 10 years by an “equilibrium” multiplier equal to 1 divided by k-times the yield on AAA-rated corporate bonds. Graham then established lower and upper price bounds equal to 80% and 120% of the central value estimate respectively. A summary of the valuation formula is provided below:
Graham explained that when a stock’s market price trended near or exceeded the upper price bound (that is, 120% of its central value), then investors could expect the market to fall or move sideways until it was back within the central value range. At these time, investors should consider shrinking their positions or taking some profits. Similarly, Graham explained that when the market price trended near or fell below the lower price bound (that is, 80% of its central value), then investors could expect the price to rise until it was back within the central value range. At these time, value investors should consider growing their positions.
It is important to note that in Graham’s original model α=10 and k=2. That is, he capitalized a firm’s 10 year average earnings at 1 divided by twice the AAA-rated corporate bond yield. While this approach is intuitively sound, based on our experience it does not always yield the most satisfactory results. To determine the values of “α” of “k” for our model results, we rely on an optimization procedure that varies the parameter value “k” one-by-one for each of the current year, 3-year, 5-year and 10-year moving average EPS series until “k” converges on a “best fitting” series. The best fitting series that minimizes the sum of squared forecasting residuals is then used in combination with next period consensus EPS estimates to determine a central value forecast. Lower and upper price bounds are then set at 80% and 120% of the central value respectively. In addition, for our model results, we do not simply rely on the average AAA rated corporate bond yield in the broad market, we rely on the effective bond yield of the company’s own debt issues. For capitalization purposes this yield must be no lower than the 10-year government bond yield.
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Price Tracking in Excel
Target price estimates and valuation ranges for all companies covered in the S&P 500 are available online, with monthly price refreshes, and are downloadable in Excel spreadsheet format under license from SEENSCO. The spreadsheet service is available with one-year subscriptions and is accessible via your online accounts. This service allows for up-to-date monitoring of return potential expectations.
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