One trade surpasses 20 years of investment! Graham invests in growth stocks with a single formula.

Graham's growth stock investment philosophy.

Known as the father of value investing, the godfather of Wall Street, and Warren Buffett's mentor... these are the titles that easily come to mind when we mention Benjamin Graham.

This article roughly introduces Graham, the father of value investing, and we can also learn from it 10 stock selection indicators and their applications summarized by Graham in his later years.

However, although Graham is known to the public for value investing, he has another side! In his later career, he began to realize the investment value of growth stocks.

How did this happen? After a series of market experiences (prosperity, crash, recovery, bull market, etc.) since the 1920s, Graham realized that market prices were irrational, so he no longer regarded prices as indicators of value judgment, but paid more attention to whether stocks had a safety margin. Moreover, he also felt the long-term power of growth, believing that investing in growth stocks can measure safety margins through expected returns.

In the epilogue of "The Intelligent Investor," Graham mentions a growth stock investment he made. He and his partner bought a lot of shares of GEICO at $27 per share (which then accounted for about a quarter of his assets), and in the following years, the stock price rose to $54,000. Through this investment, their profits far exceeded the total of all their other investments in the past 20 years!

Graham's attitude toward investing in growth stocks is that as long as the price is not high, this type of stock is very suitable for investment and holding. In addition to the company's growth bringing profits to investors, another important reason why Graham recognizes growth investment is "compound interest."

Assuming investment in Company A (value type) receives a dividend yield of 6% per year and a price increase of 5%, resulting in a total annualized return of 11%, and investment in Company B (growth type) receives a dividend yield of 1% per year and a price increase of 10%, resulting in a total annualized return of 11%, which one looks better?

For long-term investors, the advantage of Company B may be more obvious. Because choosing Company A requires more consideration of dividend reinvestment, and reinvestment is easily affected by future stock price levels.

Graham's growth stock valuation formula.

So what is Graham's summary of growth stock investing? He proposed a growth stock valuation formula, which he and his partners developed through various studies and is very close to the results of complex mathematical calculations, as follows:

Let's take a closer look at this formula below.

1. This is a formula for estimating intrinsic value. When applied, it is more about calculating the intrinsic value per share and then comparing it with the existing stock price to form an investment strategy.

2. So if we are calculating the intrinsic value per share, the current profit here is the earnings per share (EPS) of the period. Why normalize? How to normalize?

We need to normalize the earnings per share based on factors such as the overall economic cycle, industry development cycle, and investment lifecycle in which the company is located.

For example, sometimes we will confuse cyclical rebounding earnings with long-term earnings status, so in some special cases, such as when a company has experienced a period of decline and has high earnings growth in the short term, It is necessary to smooth these earnings over a longer period, which is a kind of normalization.

For example, if there is an economic or industry recession, based on the expectation of improvement in the future, the current earnings per share can be increased, while in a prosperous period, the opposite is true. If the company is developing rapidly, the earnings per share can also be increased.

3. The expected annual growth rate here refers to the average annual growth rate expected in the next 7-10 years.

Because it is an estimate, there is an inaccuracy, so there can be a range. For example, if it is believed that a company will grow at a rate of 8% per year, the range can be expanded to 6%-10%.

It is also necessary to note that the growth rate of fast-growing companies will gradually slow down. According to Graham's growth stock investment strategy, empirical research shows that the annual growth rate of most companies will inevitably drop to around 7%.

There is one point, when we actually calculate, we use the percentage of growth in the expected year in this section. For example, if the growth rate is 10%, the number used in the formula is 10. Graham's calculation method for reasonable PE ratio is

4. (8.5+2*expected annual growth rate) is the calculation method for the reasonable PE ratio that Graham believes. As for how 8.5 and 2 times multiplier are obtained, there is no more disclosure, but it is based on the Graham team's research.

5. We know that PE Ratio = Stock Price/Earnings Per Share, so the reasonable PE ratio mentioned in point 4, multiplied by the current normalized earnings per share, is the reasonable intrinsic value per share. Please use your Futubull account to access the feature.

Here, we can slightly adjust the language of this formula to make it more understandable: Intrinsic value per share = current earnings per share EPS (normalized) * (8.5 + 2 * expected average annual growth rate for 7-10 years in the future).

For example, if the current normalized earnings per share of companies A, B, and C is 2 US dollars, and their expected annual growth rates are 0%, 5%, and 10%, respectively. According to this formula, we can calculate that their reasonable intrinsic value per share is USD 17, USD 37, and USD 57 respectively, which intuitively reflects the different company growth rates in stock valuation.

In summary, this is a valuation formula that mainly considers the two dimensions of a company's profitability and growth ability. Although it is called a growth stock valuation formula, it should also be applicable to value stocks.

How to better apply this formula?

However, this formula of course also has its flaws and things to pay attention to. How can we apply it better? Here are a few points:

1. In addition to calculating the current intrinsic value, future perspectives can also be considered.

For example, based on the logic of long-term investment, we can estimate the intrinsic value per share of a company in 7 years and decide whether to buy at the current stock price based on whether it meets our expected return level.

This requires first calculating the expected earnings per share based on the current normalized earnings per share and the expected earnings per share growth rate. Then, use Graham's growth stock valuation formula to calculate the expected future intrinsic value per share.

Finally, combine the current stock price with the expected return rate to get an expected stock price. For example, if a company's current stock price is USD 10 and you expect an annual return rate of 8%, then you would expect a stock price of approximately USD 17 seven years later.

If this expected stock price is higher than the expected intrinsic value per share, it means that the investment does not meet expectations; if this expected stock price is lower than or equal to the expected intrinsic value per share, it is considered satisfactory.

2. It is necessary to establish a security perimeter.

Safety margin is a principle that Graham emphasizes. How can we consider the safety margin in the application of this formula?

By increasing our understanding of the company, we'll be able to have a better understanding of the factors that the valuation formula doesn't consider, such as non-operating assets and liabilities. As for how to learn and analyze a company, you can refer to our financial report course "US Stock Investment Starting with Deep Reading of Financial Reports".

Based on the understanding of the company, reasonable expectations must be made for future growth. Typically, an average annual growth rate above 10% is rare, and as mentioned earlier, the growth rate of many companies will drop to 7% or below in a few years. Therefore, numerical expectations for growth rates need to be controlled. In addition, as mentioned earlier, setting a range for expected growth rates also helps to invest more rationally.

When calculating the expected stock price, a minimum acceptable expected rate of return can also be used to calculate the highest buy-in price. Alternatively, a safety factor (between 0 and 1) can be considered to discount the intrinsic value per share and leave a higher margin of safety.

Or, a safety factor (between 0-1) can also be considered to discount the intrinsic value and leave a higher safety margin.

3. Consideration should be given to the impact of interest rates.

If the market interest rates decrease, it is generally bullish for the stock market, so a little premium can be added to the intrinsic value. If the market interest rates rise, the reverse is true, which can result in a discount on the intrinsic value. However, this requires a certain degree of certainty in predicting future interest rates. Therefore, if you are not sure whether interest rates will rise or fall, it is best not to adjust the intrinsic value too easily. Otherwise, it is easy to deviate from the actual interest rate changes, resulting in overvaluation or undervaluation, causing buying prices to be too high or missing investment opportunities.

However, this requires a certain degree of certainty in predicting future interest rates. Therefore, if you are not sure whether interest rates will rise or fall, it is best not to adjust the intrinsic value too easily. Otherwise, it is easy to deviate from the actual interest rate changes, resulting in overvaluation or undervaluation, causing buying prices to be too high or missing investment opportunities.

4. We cannot directly screen large-scale stocks through this formula, but with the help of the methods mentioned in 'The 10 Indicators in Stock Selection' by the 'Father of Value Investing', Graham, we can determine.

Okay, did Graham's growth stock investment method that we explained today help you? Feel free to share your thoughts with us.