Seeking Alpha
Profile| Send Message|
( followers)  

During the last two years, the Dow Jones Industrial Average increased by 72%. The striking performance of stock prices triggers concern about whether the stock market is overvalued or not. From a bullish perspective, the fundamentals are strong: The increase in stock prices can be attributed to the fast recovery from depression and increasing corporate profits.

If we look at the current valuations from a bearish side, a sharp correction is inevitable to normalize stock prices: Close-to-zero interest rates make it easier to borrow and invest using borrowed money. As long as there is someone else who is willing to pay more for the stocks, prices will rise. That is why stocks have high returns.

I decided to look at the common stock valuations from Benjamin Graham’s perspective. Known as the father of value investment, Benjamin Graham was an economist and a professional investor. Warren Buffett points to him as the second most influential person in his life after his father. In his famous book, “Security Analysis” (1962), Graham describes his simple valuation formula as such:

Long Term Valuation = EPS x (8.5 + 2 x average EPS growth)

Note that this is a long-term valuation. It does not imply any target price estimate. Moreover, according to this formula, loss-making companies are worth zero. However, the method can still be used to calculate the margin of safety.

The percentage difference between the valuation price and current price gives us the margin of safety:

Margin of Safety = (Valuation – Price) / Valuation

Graham suggests choosing the undervalued stocks with the highest margin of safety. Warren Buffett explains the margin of safety principle as paying $70 for a stock with an intrinsic value of $100. Applying this method to DJI stocks gives us the following:

Company

EPS

EPS Growth

Current Price

Graham Benchmark

Margin of Safety

Alcoa (NYSE:AA)

0,22

15,00%

16,18

8,47

-91,04%

American Express (NYSE:AXP)

3,35

10,25%

43,02

97,16

55,72%

Boeing (NYSE:BA)

4,45

10,11%

69,57

127,83

45,58%

Bank of America (NYSE:BAC)

0,00

8,50%

13,83

0,00

Caterpillar (NYSE:CAT)

4,14

18,84%

100,97

191,18

47,18%

Cisco Systems (NASDAQ:CSCO)

1,32

11,85%

18,5

42,49

56,46%

Chevron (NYSE:CVX)

9,48

17,93%

103,47

420,71

75,41%

EI DuPont (NYSE:DD)

3,30

7,35%

53,06

76,55

30,69%

Walt Disney (NYSE:DIS)

2,26

12,98%

43,29

77,90

44,43%

General Electric (NYSE:GE)

1,15

14,58%

20,32

43,31

53,08%

The Home Depot (NYSE:HD)

2,01

12,82%

36,66

68,62

46,57%

Hewlett-Packard (NYSE:HPQ)

3,94

10,10%

43,24

113,13

61,78%

International Business Machines (NYSE:IBM)

11,58

10,64%

160,16

344,87

53,56%

Intel (NASDAQ:INTC)

2,01

11,00%

21,49

61,31

64,95%

Johnson & Johnson (NYSE:JNJ)

4,78

6,16%

60,81

99,53

38,90%

JPMorgan Chase (NYSE:JPM)

3,97

8,00%

45,21

97,25

53,51%

Kraft Foods (KFT)

1,42

9,10%

31,49

37,91

16,93%

Coca-Cola (NYSE:KO)

5,05

8,47%

64,43

128,46

49,84%

McDonald's (NYSE:MCD)

4,58

10,21%

74,69

132,44

43,60%

3M (NYSE:MMM)

5,63

11,48%

91,32

177,12

48,44%

Merck (NYSE:MRK)

0,28

5,24%

32,58

5,31

-513,07%

Microsoft (NASDAQ:MSFT)

2,36

10,55%

26,08

69,86

62,67%

Pfizer (NYSE:PFE)

1,02

1,47%

19,19

11,67

-64,42%

Procter & Gamble (NYSE:PG)

3,67

8,89%

62,41

96,42

35,27%

AT&T (NYSE:T)

3,21

6,21%

28,17

67,12

58,03%

Travelers (NYSE:TRV)

6,67

8,57%

58,81

170,96

65,60%

United Technologies (NYSE:UTX)

4,74

10,33%

82,05

138,22

40,64%

Verizon (NYSE:VZ)

0,90

5,74%

36,34

17,98

-102,10%

Wal-Mart (NYSE:WMT)

4,20

9,84%

51,97

118,39

56,10%

Exxon Mobil (NYSE:XOM)

6,21

10,15%

85,08

178,85

52,43%

Average

3.60

10.08%

16,78%

The current average margin of safety of Dow Jones companies excluding Bank of America (BAC) is 16.78%. However, if we exclude overvalued companies with negative safety margins, the average margin of safety increases to 50%. American Express (AXP), Cisco (CSCO), Chevron (CVX), General Electric (GE), HP (HPQ), IBM, Intel (INTC), Microsoft (MSFT), AT&T (T), Travelers (TRV), Wal-Mart (WMT) and Exxon (XOM) have margin of safety values higher than 50%. American Express, General Electric, Wal-Mart, and Exxon are also among Warren Buffett's top 20 holdings. Based on the current valuations, and high safety margins, the current snapshot of the market looks promising. If Benjamin Graham were alive, he could have been on the bullish side of the market.



Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Benjamin Graham's Perspective on the Dow Jones