Known as the father of value investment, Benjamin Graham was an economist and a professional investor. Warren Buffett states that Graham is the second most influential person in his life after his father. Graham is famous for his simple yet powerful estimation rules. In his famous book Intelligent Investor (1973), Graham describes his valuation method as such:
Long Term Valuation = EPS x (8.5 + 2 x Estimated Earnings Growth)
While this formula gives practical information on the stock rankings, it does not account for interest rates or inflation. Realizing this limitation, in Renaissance of Value, Graham updates his formula using the corporate bond yields:
Value = EPS x (8.5 + 2 x Estimated Earnings Growth) x (4.4 / Corporate Bond Yield)
Note that this is a long-term valuation. It does not imply any target price estimate. Moreover, according to this valuation, companies that are currently loss-making are worth zero. However, the formula can still be used to calculate the margin of safety in the long run.
The percentage difference between the valuation price and current price gives us the margin of safety.
Margin of Safety = (Intrinsic Value â€“ Price) / Valuation
Graham suggested choosing the undervalued stocks with the highest margin of safety. Buffett explains the margin of safety as paying $70 for a stock with intrinsic value of $100. Graham is a value investor, and he also suggested choosing dividend stocks with positive earnings, strong balance sheets and reasonable P/E ratios. Applying the above formulas to Dow Jones stocks gives us the following results.
Company | Ticker | EPS growth next 5 years | Price | Intrinsict Value | Safety Margin | |
Alcoa | 3.00% | $11.86 | $9.86 | -16.88% | ||
American Express | 10.38% | $48.48 | $89.42 | 84.44% | ||
Boeing Co. | 11.66% | $62.80 | $120.15 | 91.33% | ||
Bank of America | 12.33% | $7.76 | -$43.77 | N/A | ||
Caterpillar Inc. | 21.00% | $85.16 | $244.42 | 187.01% | ||
Cisco Systems | 10.65% | $15.32 | $27.65 | 80.51% | ||
Chevron | 5.90% | $96.85 | $185.95 | 92.00% | ||
EI DuPont | 9.20% | $46.09 | $77.47 | 68.09% | ||
Walt Disney Co. | 14.27% | $32.40 | $69.93 | 115.84% | ||
General Electric | 13.76% | $15.54 | $37.17 | 139.21% | ||
The Home Depot | 13.18% | $34.00 | $62.47 | 83.73% | ||
Hewlett-Packard | 8.04% | $24.82 | $83.77 | 237.50% | ||
IBM | 10.83% | $169.14 | $296.29 | 75.18% | ||
Intel Corporation | 10.69% | $19.77 | $52.11 | 163.58% | ||
Johnson & Johnson | 6.09% | $64.28 | $69.15 | 7.58% | ||
JPMorgan Chase | 9.39% | $36.21 | $102.14 | 182.07% | ||
Kraft Foods Inc. | 9.32% | $33.95 | $37.78 | 11.28% | ||
Coca-Cola | 8.93% | $68.50 | $112.82 | 64.70% | ||
McDonald's | 10.35% | $89.93 | $115.63 | 28.58% | ||
3M Co. | 12.86% | $80.01 | $161.24 | 101.53% | ||
Merck & Co. Inc. | 4.81% | $31.92 | $20.00 | -37.33% | ||
Microsoft | 11.25% | $25.25 | $66.96 | 165.19% | ||
Pfizer Inc. | 3.28% | $18.21 | $12.89 | -29.21% | ||
Procter & Gamble | 9.14% | $62.57 | $84.20 | 34.56% | ||
AT&T, Inc. | 5.89% | $29.04 | $53.54 | 84.36% | ||
Travelers | 8.64% | $48.30 | $105.39 | 118.20% | ||
United Tech. | 12.67% | $71.56 | $139.96 | 95.59% | ||
Verizon | 8.48% | $35.76 | $45.62 | 27.58% | ||
Wal-Mart | 9.36% | $52.90 | $96.25 | 81.95% | ||
Exxon-Mobil | 8.22% | $72.64 | $151.83 | 109.02% | ||
Average | 10.08% | 88.01% |
Stock market date is derived from Finviz, and corporate bond data is retrieved from the Federal Reserve Bank of St. Louis. EPS growth estimate for Alcoa is derived from Morningstar.
The current average margin of safety of Dow Jones companies excluding Bank of America is 88.01%. Bank of America is the only company in a DJI index that did not report any profits. Caterpillar, Walt Disney, General Electric, Hewlett Packard, Intel, JPMorgan Chase, MMM, Microsoft, Travelers and Exxon have more than 100% margin of safeties. Based on the current valuations, and high safety margins, the current snapshot of the market looks promising. If Graham were alive, he could have been on the bullish side of the market.
Both intrinsic value and margin of safety are dynamic concepts. They are highly dependent on analystsâ€™ long-term EPS growth estimates. I used the five-year EPS growth estimates as a proxy for the long-term estimates. Here is a brief summary of the top DJI stocks with the highest margin of safety:
Caterpillar is trading with a P/E ratio of 14.08 and a forward P/E ratio of 9.28. It pays a yield of 2.16%. Based on 21% EPS growth estimate, the stock offers 187% margin of safety.
Walt Disney is trading with a P/E ratio of 13.73 and a forward P/E ratio of 11.03. It pays a yield of 1.23%. Based on 14.27% EPS growth estimate, the stock offers 116% margin of safety.
General Electric is trading with a P/E ratio of 12.05 and a forward P/E ratio of 9.65. It pays a yield of 3.86%. Based on 13.76% EPS growth estimate, the stock offers 139% margin of safety.
Hewlett-Packard is trading with a funky-low P/E ratio of 5.83 and a forward P/E ratio of 5.09. It pays a yield of 1.93%. Based on 8.04% EPS growth estimate, the stock offers 237% margin of safety. I think it is one of the cheapest stocks in the market with great bouncing potential.
Intel Corporation, a dividend stock pick for the next FIVE years, is trading with a P/E ratio of 9.07 and a forward P/E ratio of 8.14. Yield is 4.25%. Based on 10.69% EPS growth estimate, the stock offers 164% margin of safety. My FED+ Fair Value range for Intel is $26-34. (Full analysis here.)
JPMorgan Chase is trading with a low P/E ratio of 7.74 and a forward P/E ratio of 6.48. Yield is 2.76%. Based on 9.39% EPS growth estimate, the stock offers 182% margin of safety.
MMM is trading with a P/E ratio of 13.58 and a forward P/E ratio of 11.68. Yield is 2.75%. Based on 12.86% EPS growth estimate, the stock offers 101% margin of safety.
Microsoft, a dividend stock pick for the next FIVE years, is trading with a historical low P/E ratio of 9.35 and a forward P/E ratio of 8.07. Yield is 2.53%. Based on 11.25% EPS growth estimate, the stock offers 165% margin of safety. My FED+ Fair Value range for Microsoft is $40-46. (Full analysis here).
Travelers is trading 25% lower than its 52-week high, offering a good entry point. It is trading with a P/E ratio of 9.45 and a forward P/E ratio of 8.04. Yield is 3.40%. Based on 8.64% EPS growth estimate, the stock offers 118% margin of safety.
Exxon is trading with a single digit P/E ratio of 9.55 and a forward P/E ratio of 8.09. Yield is 2.59%. Based on 8.22% EPS growth estimate, the stock offers 109% margin of safety.