There are several valuation metrics/methods that help identify potentially undervalued stocks, and you may have tried a number of them. But have you tried the Graham Number?

A quick check through the Graham Number can help determine whether a company might be worth a look, before the market realizes how good a deal it is.

What is the Graham Number?

It is named after the “father of value investing,” Benjamin Graham, who was a mentor of Warren Buffett. The figure takes into account earnings per share and book value per share to measure a stock's maximum fair market value. In other words, it is the upper end of the price range that a defensive investor should pay for the stock.

Theoretically, any stock trading below its Graham Number is considered undervalued.

The formula is as follows:

The Graham Number = Square Root of (22.5) x (TTM EPS) x (MRQ Book Value per Share).

The 22.5 is included in the formula as a rule of thumb to account for Graham's assumption that the price-to-earnings ratio should not be over 15 and the price to book ratio should not be over 1.5 for an undervalued stock. So, the number is generated as: (P/E of 15) x (P/B of 1.5) = 22.5.

But keep in mind that a discount to the Graham Number is not always worth getting excited about. Though the calculation is easier and takes only a few minutes, it does not consider many fundamental characteristics and ratios which are also important to identify promising undervalued stocks.

It all depends on your investment strategy. So use a combination of Graham Number and other fair market value calculations using other financial ratios or statistics before making a final investment decision.

We can’t call this strategy "foolproof," but it can be an easy starting point for your research.

Confirmation with Zacks Rank

A good way to confirm your choice is to look at the stock’s Zacks Rank. The Zacks Rank is a proprietary quantitative model that uses trends in earnings estimate revisions to classify stocks into five groups: Zacks #1 Rank = Strong Buy, Zacks #2 Rank = Buy, Zacks #3 Rank = Hold, Zacks #4 Rank = Sell and Zacks #5 Rank = Strong Sell. The earnings estimates in the Zacks Model come from brokerage or “sell-side” analysts.

Now, if you see that your target stock holds a Zacks #1 or #2 Rank, buying it could give you above-average returns.

(To learn more about the Zacks Rank, visit our Zacks Rank Education section.)

Three Stocks Undervalued by the Graham Number

While there are several value stocks that you may add to your portfolio based on the above strategy in the current oversold market, we believe the following three would be good additions:

Reliance Steel & Aluminum Co. ( RS - Analyst Report ) - Analyst Report): A metals service center company that operates predominantly in the United States and Canada. It holds a market capitalization of $3.7 billion.

• Earnings Per Share (TTM) = $4.89
• Book Value per Share (as of March 31, 2012) = $43.63
• Graham Number = SQRT (22.5 x $4.89 x $43.63) = $69.28

The stock is currently trading at $49.18 (closing price on May 21, 2012), implying a discount of 29.0% from the Graham Number or fair market value. Currently, the company also has a Zacks #1 Rank.

MidWestOne Financial Group, Inc. ( MOFG - Snapshot Report ) - Snapshot Report): A holding company for MidWestOne Bank that offers retail banking products and services for individuals, businesses, governmental units and institutional customers. It has a market capitalization of $177.3 million.

Earnings Per Share (TTM) = $1.68
Book Value per Share (as of March 31, 2012) = $18.81
Graham Number = SQRT (22.5 x $1.68 x $18.81) = $26.66

The stock is currently trading at $20.94 (closing price on May 21, 2012), implying a 21.5% discount to the Graham Number. This is also a Zacks #1 Rank company.

Access National Corp. ( ANCX - Snapshot Report ) - Snapshot Report): With a market capitalization of $129.5 million, this is a bank holding company for Access National Bank, which offers credit, deposit and mortgage services to businesses and professionals in the northern Virginia region and the Greater Washington, D.C. metropolitan area.

• Earnings Per Share (TTM) = $1.21
• Book Value per Share (as of March 31, 2012) = $8.38
• Graham Number = SQRT (22.5 x $1.21 x $8.38) = $15.10

The stock is currently trading at $12.66 (closing price on May 21, 2012), implying a discount of 16.2% from the Graham Number. The company also carries a Zacks #1 Rank.

Be Careful

The strategy is no doubt a smart and easy way to benefit from the stock market. History affirms that this strategy has helped generate strong returns during bear markets since the Great Depression of the 1930s. And history always repeats itself!

One note of caution: you should not rest assured by targeting a stock based only on the Graham Number. It is also important to try and determine the reason for the undervaluation.

If the reason for a depressed stock price is difficult to find out or understand, it could have the potential to materially reduce the intrinsic value of the company and lead to a loss of capital.

Therefore, instead of searching for undervalued stocks based on only quantitative factors or ratios first, it’s better to identify areas of the market where undervaluation is likely to remain due to short-term reasons.

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