by Tim Melvin | February 14, 2014 10:29 am
Benjamin Graham developed a formula for selecting stocks using a range of criteria. He said that stocks should be purchased below 15 times earnings and less than 1.5 times book value most of the time. And even if you adjusted for particularly strong earnings growth or attractive assets the price-to-book-value ratio multiplied by the price-to-earnings ratio should always be less than 22.5.
It is fairly easy to reverse engineer that to come up with an estimate of fair value for a company, and analysts call it the Graham number. It’s a good, quick-and-dirty estimate of a business’s fair value, which can then be measured against its stock price.
This calculation can be used to find companies that trade well below the fair value estimate and may be bargain issues. I find it most interesting to search for companies that are showing strong earnings growth and are still undervalued by the marketplace. These stocks may not fit my classic deep value definition, but they have outstanding performance and prices that can still be a bargain for growth oriented investors.
Proassurance (PRA) is such a company. The specialty property and casualty insurance company primarily sells professional liability insurance for providers of health care services and, to a lesser extent, providers of legal services. PRA also offers product liability products for healthcare and life sciences professionals and companies. PRA stock has grown its earnings for the last decade by about 20% per year but trades at just 8.5 times earnings and 1.2 times book value. At just 70% of its Graham value, PRA stock would have to gain 50% or so to be fairly valued, based on its combined earnings and asset value.
Titan Machinery (TITN) operates full-service agricultural and construction equipment stores in the United States and Europe. It has 105 North American dealerships spanning the Midwest to the Southwest, as well as 14 dealerships in Eastern Europe. TITN has grown earnings by more almost 50% annually for the past decade, and although it has slowed a bit the five-year growth rate is still close to 25% per year. TITN stock currently trades at 75% of its Graham number value and could be a stellar performer as the economy improves later this year.
Brookfield Office Properties (BPO) has shown solid earnings growth of more than 20% across both the five- and 10-year periods. The company owns premier office properties in major cities around the world and trades at a discount of about 50% of its Graham number value. There is a unique opportunity here, as it is being taken over by Brookfield Properties (BPY), a commercial property REIT that also has high-quality assets all over the globe. It is a one-to-one share exchange, and BPO shares are also currently trading for just half of their Graham valuation. Upon the completion of the merger, investors will own one of the best collections of commercial and office properties in the world at a discount to the value of the assets and earnings power.
A good Graham number alone isn’t a sufficient reason to invest in a stock, but it is a good indication of which stock are attractively valued. These three stocks are prime examples of the kinds of deals the Graham formula can help you find.
As of this writing, Tim Melvin did not hold a position in any of the aforementioned securities.
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