One helpful way to find potentially undervalued opportunities is from the “Godfather” of value investing himself, Benjamin Graham.
Graham created an equation to calculate the maximum fair value for a stock, referred to as the “Graham Number.” Any stock trading at a significant discount to this number would appear undervalued.
For this list, we focus on S&P 500 companies. We used the Graham Number to screen for potentially undervalued stocks among a universe of highly profitable S&P 500 stocks that beat the industry average in all of the following ratios:
- Gross margin
- Operating margin
- Pretax margin
The current market downturn has made these stocks even more undervalued on a Graham Number basis. Want a closer look at these terms and why they’re valuable tools in trading and investing? Let’s review:
Market Capitalization (Market Cap)
Market capitalization, commonly referred to as market cap, is the total market value of a company’s outstanding shares. It can be thought of as a measure of company’s size. It can be calculated by multiplying the number of shares by the current price of the shares.
According to Benjamin Graham, a former mentor of Warren Buffett and the so-called “Godfather” of value investing, the Graham Number is the maximum price that a value investor should pay for a given stock. A stock whose share price is below the Graham Number is considered to be undervalued, or of good value.
It is a calculation for the fair-value price of a stock based on its earnings per share (EPS) and most recent quarter’s book value per share (the value of the company’s assets divided by the number of shares).
Graham Number = Square Root of (22.5) x (TTM EPS) x (Most Recent Quarter (MRQ) Book Value per Share).
We use trailing twelve month (TTM) diluted EPS. TTM is an indication that the calculated data has come from the last 12 months.
TTM Gross Margin
This metric tells us the percentage of a company’s revenue left over after paying all production expenses. Costs include overhead, payroll, and taxation.
TTM Gross Margin = ((Revenues – Cost of Goods Sold) / Revenue ) x 100
This tells us the percentage remaining after all operating expenses are paid. Operating expenses include: supplies, repairs, research and development, and depreciation.
Operating Margin TTM = (Operating Income / Net Operating Revenue) x 100
A company’s earnings before taxes. This incorporates all of the expenses associated with business, excluding taxes. It can help to determine the overall operating efficiency of the firm. The higher the pretax margin, the more profitable the company.
Pretax Margin = (Net Profit before Taxes / Net Sales) x 100
Now that you’re armed with information, take a look at the three deeply undervalued stocks, as indicated by their respective Graham Numbers.
Next: 3 Deeply Undervalued Stocks…