A common expression years ago, was playing the stock market. The expression came from the fact that many thought of stock investing as gambling on whether stocks would go up or down. Traders listened for stock tips with fond hopes of getting into a stock before it ran up in price and out of a stock before it went bust. After the stock market crash that ushered in the Great Depression, Benjamin Graham taught how to avoid losing money in the stock market by learning to calculate the intrinsic value of a given stock. What is intrinsic stock value? The intrinsic value of a stock is generally referred to as the forward looking value of the stock discounted to present circumstances. Mr. Graham devised a formula so that investors could make a rational decision about whether or not to buy or sell a stock. How to avoid losing money in the stock market is to use tools like the Graham intrinsic value formula and your own good common sense when investing in stocks.
Intrinsic Stock Value
Here is a thumbnail view of the Graham formula for calculating intrinsic stock value in 1962 and modified in 1974. The 1974 version considers the following:
- Earnings per share, EPS, for the preceding twelve months
- A constant of 8.5 representing an expected price to earnings ratio, P/E ratio, for a company that is not growing
- An estimate of long term growth, five years = g
- A constant of 4.4 which was the average yield of high grade corporate bonds in the early 1960 decade
- The current yield of AAA corporate bonds = Y
- Where V = intrinsic value
The formula is as follows:
V = (EPS x (8.5 + 2g) x 4.4)/Y
The point of this formula is to calculate the RGV or Relative Graham Value. Do the calculation to find V. Then divide V by the current stock price. This gives you the RGV.
- If the RGV is less than one the stock is overvalued and a bad investment
- If the RGV is greater than one the stock is undervalued and may be a good investment
The stock market may seem crazy at times as prices swing up and down according the mood of investors. However, the eventual price of any stock will be determined by a given set of fundamentals. How to avoid losing money in the stock market and instead make a comfortable income is to learn how to evaluate and act upon the fundamentals. What products and services does a company produce? What is their cost and how much of a profit do they make? What is their competition and does the company engage in research and development to make new things? How much debt does the company have and is there any problem servicing that debt. And, is there hidden value in a company that protects it against losses and could be exploited to increase returns? This process of investigation is called fundamental analysis and is how to make money in stock and how to avoid losing money in the stock market. It is important to remember that very successful investors never ever invest in a company unless they know exactly how the company makes its money and how it insures that it will do so in the future.