This guest contribution is from Ben Reynolds at Sure Dividend. Sure Dividend uses The 8 Rules of Dividend Investing to systematically identify high quality dividend growth stocks.

Benjamin Graham is known as the ‘Dean of Wall Street’. He is the father of value investing and mentor to Warren Buffett.

Graham did more than mentor and think about investing philosophy. He was a phenomenal investor in his own right. Graham’s investment partnership average returns of around 20% a year – for 20 years. 20% returns over 20 years turns $1 into over $38. Graham’s investment methods worked amazingly well… From 1936 to 1956 when he operated his partnership.

Do Graham’s methods still work well today?

Graham had several different quantitative screening methods to determine which stocks are trading at attractive valuations.

This article applies ‘the Graham Number’ (one of his formulas) to the S&P 500.

The Graham Number

The Graham Number is used to quickly determine if a business is trading at or below fair value. The Graham Number formula is shown below:

The Graham Number assumes that a fair price-to-earnings ratio is 15 and a fair price-to-book ratio is 1.5. Interestingly, the historical average price-to-earnings ratio for the S&P 500 is 15.6. Graham was eerily close to the ‘fair value’ of stocks with his formula – which he made over 60 years ago.

If the Graham number is more than the current share price, the stock is undervalued. If the Graham number is less than the current share price, the company is overvalued.

The Graham number quickly weeds out overpriced businesses. You won’t invest in the Facebooks (FB), Googles (GOOG), or Amazons (AMZN) of the investing world by using the Graham number.

The S&P 500 is currently trading for a price-to-earnings multiple of around 25. As a result, fewer businesses will ‘pass’ the Graham Number now versus when stock prices are depressed – say during Great Recession lows in March of 2009.

The Graham Number Meets the S&P 500

Applying the Graham Number to the S&P 500 yields interesting results.

Only 58 businesses pass the Graham Number valuation screen. You can download a valuation spreadsheet of all S&P 500 stocks valued using the Graham Number here.

Only 11.6% of S&P 500 stocks pass the Graham Number screen. This is because the market is currently trading far above its historical average price-to-earnings ratio.

Of the 58 stocks that do pass the Graham test, 34 are in the financial sector. This is because financial sector stocks tend to have lower price-to-book ratios.

Graham’s Greatest Student

To what extent is Warren Buffett influenced by Benjamin Graham?

Warren Buffett is quoted as saying (in response to a similar question): “I’m 15% Fisher (referring to legendary investor Philip Fisher) and 85% Graham”.

Clearly, Buffett is heavily influenced by Graham. Buffett holds a highly concentrated portfolio of under 40 stocks – and his top 4 holdings make up over 60% of his portfolio. Buffett’s largest investments are all in higher yielding stocks. His top 4 holdings have an average dividend yield of ~3.%.

Interestingly, 5 of Buffett’s holdings pass the Graham Number test. They are:

Wells Fargo (WFC)

Goldman Sachs (GS)

General Motors (GM)

The Bank of New York Mellon (BK)

M&T Bank (MTB)

These 5 stocks comprise 22% of Buffett’s total portfolio – a large portion. Most of this weight is attributed to 1 stock; Wells Fargo.

How to Use the Graham Number Today

The Graham Number is less useful today than it was 50 years ago. That’s because the United States economy is becoming less asset intensive. Technology business like Google and Facebook are relatively asset light. They don’t expand by opening new factories for additional capacity like many businesses did in Graham’s time.

The same is true for asset light consumer goods businesses. Coca-Cola (KO), Apple (AAPL), and Procter & Gamble (PG) grow through advertising and consumer awareness. Coca-Cola isn’t going to sell more soda by tripling its capacity to make syrup; it grows by spreading brand awareness. This doesn’t show up on the balance sheet.

As a result, you see consumer goods businesses and tech businesses that trade at large multiples to book value – even if the price-to-earnings ratio is reasonable. This throws a giant monkey wrench into the workings of the Graham Number formula. It simply isn’t good at valuing many of the businesses in the market today.

But that doesn’t mean the Graham Number is useless…. Quite the contrary.

The Graham Number is still a powerful tool when used to analyze insurance companies, banks, and other businesses that make their money based in large part off of the size of their asset base.

The Graham Number can be used on entire industries (like banking or insurance) to quickly determine which businesses make good candidates for further research.