Earlier today I was feelingĀ kinda lonely. š„Ā So I decided to buy some shares.
Ah yes. It sure feels goodĀ to have a bit of company. šĀ And that company is calledĀ Costco.

In this series of blog posts I’ll explain how I determine which stocks to add to my portfolio based on strategic valuation methods. š

## How to Value a Stock: The Graham FormulaĀ

Today, we’ll look at one of the most common formulas to determine the intrinsic value of a company; it’s call the Benjamin Graham Formula, named after the famous value investor who taught Warren Buffett. š

The Graham formula looks like the following:

This should give us an idea of how much we should pay to buy a stock. Let’s go over the variables.

V = Intrinsic value, or what the stock should be worth today.
EPS = Trailing twelve months earningsĀ per share.
8.5 = P/E base for a no-growth company.
g = Expected long term earnings growth rate.

## Is Costco Stock Undervalued or Overvalued?

This formula works best with blue-chip, large cap, value stocks. We will use Costco Wholesale Corporation as an example since I just purchased someĀ recently. š

So to find out the intrinsic value of CostcoĀ (NASDAQ:COST) we need to look up the earnings per share (EPS). This information can be found on Google Finance. Ā We see that it’s \$5.41.

Next in the formula, weĀ need the “g” value. We can find this information on the Nasdaq.com website, and see that it’s 10.71%.

Finally we can now plug everything into the formula to see the result.

So as of today, March 23rd, Costco should be worth around \$162 per share according to the Benjamin Graham formula.

But of course the stock is actually trading at \$167. This means Costco is currently overvalued because its shares areĀ trading at a premium compared to the fair value we just calculated.

Nevertheless, I still went ahead and purchased 10 shares of Costco this morning. The 3% premium I paid over the intrinsic value isn’t a big deal for me. Plus Costco recently announced an increase of membership fees to \$60 per year. Like most other Costco shoppers I have decided to keep renewing my membership with them. But at least now I own 10 Costco shares, which entitles me (as a shareholder) to receive US \$54 of after tax profits every year. This amount converted into Canadian dollars is more than enough to cover the expense of my annual Costco membership, haha. š

## Is the Stock Market Overvalued?

My opinion is yes.Ā This post will explain how I came to this conclusion. Thanks to reader Bricks for bringing up this topic.

We’ll be looking at the S&P 500 because it’s a popular index and there’s a lot of data available for it. š This index basically represents a basket of 500 large publicly traded companies in the United States. We can analyze the following 7 metrics to determine how cheap or expensive the market is. And naturally each of these ratios below can be applied to individual stocksĀ as well. š

1. Trailing P/E ratio
2. Forward P/E ratio
3. Forward P/S ratio
4. Price vs Forward Earnings
5. Shiller P/E Ratio
6. Operating Margins
7. EV / EBITDA ratio

## UsefulĀ RatiosĀ to Value the Stock Market

1) P/E Ratio – The price to earnings ratio, or sometimes known as the trailing P/E ratio or TTM P/E ratio, is a popular measurement to help determine the valuation of stocks. A low P/E ratio signals a cheap valuation. Historically the P/E ratio of stocks in both Canada and the U.S. hover between 10 to 20 most of the time. However, as of today the P/E ratio of the S&P 500 index is about 22, which signals it is overpriced relative to the norm. (image source)

2) Forward P/E Ratio –Ā Unlike the trailing P/E ratio, the forward P/E ratio uses projected future earnings. Of course nobody knows how much money companies will make in the future, but this metricĀ provides a sentiment of how profitable the market feels about the next few earnings seasons. According to a FactSet report, the forward P/E ratio of the stock market is 16.5, which is above the long-term average of 14.2. So based on this data stocks are currently about 16% more expensive than what they should be.

3)Ā Forward P/S Ratio –Ā The price to sales ratio compares the total market value to revenue. It usually moves in the same direction as the P/E ratio but can provide a smoother, more accurate depiction of the market’s valuation (see yellow line in chart above.) This ratio is currently over 1.6xĀ for the S&P 500,Ā which suggests the market is overpriced, even compared to 2008 levels.

4) Price Change vs Forward Earnings Change– The price of the stock market is mainly determined byĀ its future profitability. But recently the price has diverged away from future expected earnings which suggests stock prices are too high.

Notice what happened after the last time price diverged higher fromĀ the forward expected EPS in 2006 and 2007. š

According to John Butters, senior earnings analyst at FactSet, for the first quarter of 2016 it appears 92 companies have issued negative EPS (earnings per share) guidance and only 26 companies have issued positive EPS guidance. This depicts a rather bearish outlook. However, stock prices have not come down nearly enough to reflect these estimates. š