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There is a widely respected formula for calculating the intrinsic value of a stock. It is known as the Graham Number and is pretty simple. The formula is Graham Number = Square Root of (Book Value * EPS * 22.5). With the advent of the excel spreadsheet, the old fashion abacas is no longer needed to do the calculation.

From Forbes:

Graham Number is a concept based on Ben Graham's conservative valuation of companies. It calculates the intrinsic values of companies. This is one of the ways to estimate the intrinsic value of business based on their book value and their earnings power.

Unlike valuation methods such as DCF or Discounted Earnings, the Graham number does not take growth into the valuation. Unlike the valuation methods based on book value alone, it takes into account the earnings power. Therefore, the Graham Number is a combination of asset valuation and earnings power valuation.

In general, the Graham number is a very conservative way of valuing a stock. It cannot be applied to companies with negative book values.

As I cannot seem to leave well enough alone, I like to modify these types of formulas to better suit my needs. For instance I was using the "forward PEG ratio" long before it was given a name. As my goal is to attempt to locate undervalued stocks going out two years, I have modified the Graham Number to reflect not the trailing twelve months earnings per share but anticipated 2014 eps. The advantage of this modification is it should uncover those stocks whose value is below what it should be in 2014. With so many utilities projecting earnings declines over the next two years, the modified Graham Number will catch these and reflect a lower Graham number. For instance, Entergy (ETR) is anticipated to earn $4.80 a share in 2014 versus $6.23 in 2012, partially due to the spin-off of its transmission business to ITC Corp (ITC). This reduces the Graham Number to $74.75 from $85.15.

Below are the components of the S&P Utility Index and ETF (XLU). The table includes current price, percentage undervalued or overvalued from the Modified Graham Number, the Modified Graham Number based on 2014 anticipated earnings, 2012 EPS, most recent quarter Book Value, anticipated 2014 earnings, and return on invested capital based on trailing twelve month return on equity and the most recent quarterly debt to equity.

Company

Ticker

Current Price

% to Graham Over or Under Value

2014 Modified Graham

2012 EPS

Book Value MRQ

2014 Est EPS

Return on Invested Capital

Entergy Corp

ETR

$ 63.60

-14.9%

$ 74.75

$6.23

$51.73

$4.80

3.74%

FirstEnergy Corp

FE

$ 39.96

-12.7%

$ 45.80

$3.34

$31.29

$2.98

2.37%

Exelon Corp

EXC

$ 31.44

-12.5%

$ 35.94

$2.85

$25.07

$2.29

3.41%

Pepco Holdings

POM

$ 20.86

-12.2%

$ 23.78

$1.21

$19.33

$1.30

2.90%

AES Corp

AES

$ 12.20

-10.9%

$ 13.71

$1.24

$ 6.14

$1.36

-1.04%

NRG Energy

NRG

$ 24.49

-10.4%

$ 27.34

$0.27

$31.04

$1.07

2.51%

Ameren Corp

AEE

$ 34.22

-7.4%

$ 36.99

$2.43

$27.27

$2.23

-6.47%

Duke Energy

DUK

$ 70.16

-6.8%

$ 75.28

$4.32

$58.04

$4.34

2.80%

PG&E Corp

PCG

$ 43.35

-6.2%

$ 46.26

$3.22

$30.68

$3.10

3.17%

American Elec Pwr

AEP

$ 47.60

-1.5%

$ 48.34

$3.09

$31.37

$3.31

3.72%

Public Svc Enterprise

PEG

$ 33.52

-0.1%

$ 33.57

$2.44

$21.31

$2.35

6.00%

Northeast Utils

NU

$ 42.52

0.4%

$ 42.35

$2.28

$29.42

$2.71

4.00%

Consolidated Edison

ED

$ 59.64

0.5%

$ 59.33

$3.75

$40.53

$3.86

4.96%

Scana Corp

SCG

$ 49.83

1.2%

$ 49.24

$3.19

$31.14

$3.46

4.38%

Integrys Energy

TEG

$ 57.11

1.8%

$ 56.09

$3.26

$38.84

$3.60

5.05%

Edison Intl

EIX

$ 49.89

2.3%

$ 48.76

$3.92

$28.95

$3.65

7.11%

Xcel Energy

XEL

$ 29.29

2.9%

$ 28.47

$1.82

$18.19

$1.98

4.66%

Pinnacle West

PNW

$ 57.24

4.1%

$ 54.97

$3.50

$36.20

$3.71

5.70%

TECO Energy

TE

$ 17.57

4.8%

$ 16.77

$1.15

$10.68

$1.17

4.71%

PPL Corp

PPL

$ 31.25

5.1%

$ 29.73

$2.42

$18.10

$2.17

4.88%

DTE Energy

DTE

$ 67.51

5.4%

$ 64.03

$3.94

$42.78

$4.26

4.46%

Nisource Inc

NI

$ 28.34

9.3%

$ 25.93

$1.42

$17.90

$1.67

3.18%

Nextera Energy

NEE

$ 73.84

9.4%

$ 67.50

$4.57

$37.99

$5.33

4.56%

Sempra Energy

SRE

$ 79.47

17.8%

$ 67.46

$4.35

$42.49

$4.76

3.94%

Southern Co

SO

$ 45.32

21.3%

$ 37.36

$2.70

$21.32

$2.91

5.83%

CMS Energy

CMS

$ 27.04

24.2%

$ 21.76

$1.55

$12.10

$1.74

3.60%

Centerpoint Energy

CNP

$ 21.92

25.9%

$ 17.42

$1.25

$10.06

$1.34

2.99%

Wisconsin Energy

WEC

$ 41.87

30.2%

$ 32.15

$2.35

$18.02

$2.55

5.92%

Dominion Res Inc

D

$ 56.50

45.4%

$ 38.85

$3.05

$18.84

$3.56

1.88%

Oneok Inc

OKE

$ 45.19

97.0%

$ 22.93

$1.69

$10.39

$2.25

6.65%

Average

$ 42.02

6.9%

$ 40.09

$2.67

$26.36

$2.77

3.60%

With the overall markets hitting 5-year highs, finding utility stocks that can provide some margin of safety should be paramount. While the Graham Number should be used in conjunction with dividend yield, dividend growth, and ROIC, it could be a starting place to find some sense of potentially lower risk in the sector.

What is interesting is the "riskier" firms are undervalued according to the Graham Number (modified or not) while the "safer" stocks are overvalued.

Reviewing the five most undervalued stocks by the Modified Graham Number would include Entergy, FirstEnergy, Exelon, Pepco, and AES Corp. These firms are also considered some of the dicier names in the sector due to their exposure to merchant power markets.

Of course, the safer names, such as Southern Company, Sempra and Centerpoint are trading at a substantial comparative premium to both these five and the average large cap utility.

It may be prudent to research both ends of the Graham Number - those that are higher risk with some degree of safety if earnings pan out and those that are lower risk but may not provide as much value in today's market.

Author's Note: Please review important disclaimer in author's profile.

Source: Overvalued Large Cap Utilities By Modified Graham Numbers