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Published in 1937, Ben Graham covers the basics of accounting and financial statements. It’s a condensed guide on reading the balance sheet and income statement, explaining common metrics, and tips on how to determine the soundness of a company.
The Notes
- “Ben Graham’s principle of always returning to the financial statements will keep an investor from making huge mistakes, and without huge mistakes the power of compounding can take over.” — Michael Price
- Financial statements offer a picture of a company’s financial soundness and operating results.
- “When you know what the figures mean, you have a sound basis for good business judgment.”
- “..the success of an investment depends ultimately upon the future, future developments, and the future may never be forecast with accuracy. But if you have precise information as to a company’s present financial position and its past earnings record, you are better equipped to gauge its future possibilities.”
- The balance sheet shows how much a company owns (assets) and owes (liabilities) at a particular point in time. Assets and liabilities must balance out.
- Assets = property like plants and equipment, accounts receivable, cash, intangible assets like goodwill, etc.
- Liabilities = accounts payable, current debt, long term debt plus stockholder equity, etc.
- Intangible assets can be over-inflated or deflated depending on the company. The same is true for goodwill, and assets written down through depreciation.
- “It is a common occurrence to find that the true value of a company’s assets is entirely different from the balance sheet total.”
- A company’s size can be measured by its assets or sales, relative to the other companies in the industry.
- On small-cap investing: “Where the purchase is made for speculative profits, or long-term capital gains, it is not so essential to insist upon dominant size, for there are countless examples of smaller companies prospering more than larger ones. After all, the large companies themselves presented the best speculative opportunities while there were still comparatively small.”
- The term “watered stock” was given to companies that inflated their asset value, thus inflating book value, which was later written off with special charges against earnings. Graham’s offers U.S. Steel’s inflated $600 million value in assets.
- In other words, asset values on a balance sheet may or may not represent an accurate value of an asset.
- “We suggest that the property account be neither accepted at face value nor entirely ignored, but that reasonable consideration be given to it in appraising the company’s securities.”
- Depreciation, amortization, and depletion apply a normal wearing out or aging of building and equipment over its typical lifespan. It allows the cost of the asset to be charged off (the income statement) over a series of years.
- Depletion is used in commodity businesses like mining or oil to account for resources taken out of the ground.
- Current assets listed as “marketable securities” might be a place to unearth hidden value.
- Intangible assets can’t be accurately weighed or measured. Includes patents, trademarks, goodwill, etc.
- “An investor should recognize a very strong distinction between good-will as it appears — or, more generally, fails to appear — on the balance sheet, and good-will as it is measured and reflected by the market price of the company’s securities.”
- There might be hidden value found in goodwill. If goodwill is written off, after a company has improved financially, it’s likely that goodwill is worth more than what is stated on the books.
- The real value of intangible assets is more likely found in the income statement than the balance sheet. “It is the earning power of these intangibles rather than their balance sheet valuation, that really counts.”
- Current assets are cash or assets that are easily converted into cash like receivables and inventory — and are shown in order of liquidity.
- Current liabilities are debts incurred during normal business operations to be paid or maturing within one year.
- Current Ratio = current assets/current liabilities. A high current ratio shows that the company will have no problem meeting short-term obligations.
- More liquid current assets allow for a lower margin above current liabilities.
- Working Capital (or Net Current Assets) = current assets – current liabilities.
- An excess of Working Capital makes it easier for a company to run daily operations, grow the business, and meet emergency needs without taking on new financing. A lack of working capital means its harder to cover current liabilities and likely means forgoing business growth, with a worst-case scenario of bankruptcy.
- Graham’s Net-Net Working Capital Strategy: “The working capital available for each share of common stock is an interesting figure in common stock analysis. The growth or decline of the working capital position over a period of years is also worthy of the investor’s attention.”
- Quick Ratio = (Current Assets – Inventory)/Current Liabilities
- Inventory should be looked at in relation to other factors in order to assess how efficiently the company turns assets into profit — like turnover (turnover ratio = annual sales/inventory). Inventory turnover can be compared on a year to year basis.
- Receivables can be looked at against sales and compared year to year. A large ratio of receivables to sales means the company may be at a higher risk of loss due to unpaid accounts. Also, watch for companies that allow long-term payment options.
- “During periods of depression it is particularly important to watch the cash account from year to year… In such periods the way in which the losses reflect themselves in the balance sheet may be more important than the amount of the losses themselves.”
- Stocks selling below its cash value per share may be worth more than its valued by the market. Stockholders may benefit from an appreciation in price or distribution of cash.
- “The most important individual item among the current liabilities is that of Notes Payable.” If notes payable — accounts payable — is larger then cash and receivables the company may be too reliant on credit. When looked at over several years, if accounts payable grows faster than sales and profits, then its a sign of weakness.
- Reserves is an all-encompassing term for money set aside to be used for a specific purpose.
- Graham breaks reserves into 3 classes:
- Definite liabilities — for taxes, accident claims, legal settlements, customer refunds, etc. that are closer to current liabilities
- Offset against an asset — losses on receivables, decline in inventory may be an actual decline or set up to offset a future decline (if its a future decline, it may be a surplus).
- Actually a surplus — contingency reserves or money set aside for a future purpose that is more likely not used as intended but only if it gets transferred back to surplus.
- “To avoid being deceived by these devices, the investor must examine both the income and the surplus account over several years, and make due allowance for any amounts changed to surplus or reserves which really represent business losses during the period. Also…the investors should be particularly careful not to exaggerate the significance of a single year’s earnings.”
- “The book value of a security is in most cases a rather artificial value.”
- Book value attempts to show the liquidation value of all the tangible assets, but in reality, the true liquidation value is more likely to be less than book value. The reason: inventory and fixed assets are likely to be sold at a significant loss.
- “The book value really measures, therefore, not what the stockholder could get out of their business (its liquidation value), but rather what they have put into the business, including undistributed earnings. The book value is of some importance in analysis because a very rough relationship tends to exist between the amount invested in a business and its average earnings.”
- Book Value = total assets – intangible assets – liabilities.
- Book value may be overstated or understated depending on reserves that should be considered a surplus. Reserves considered a surplus should be added into book value to get a closer approximation of the true book value.
- Net Current Asset Value (NCAV) = Current assets – liabilities and preferred stock. NCAV might be a good representation of liquidation value if current assets are a large portion of total assets. Stocks selling below NCAV may be extremely undervalued.
- “Outside of the field of banks, insurance companies, and, particularly, investment trusts, it is only in the exceptional case that book value or liquidation value plays an important role in security analysis.”
- “The book value of a common stock is usually not important, but it may be of interest where the book value is either much larger or much smaller than the market price.”
- Earning Power = a company’s expected earnings over a period of future years.
- “Since the future is largely unpredictable, we are usually compelled to take either the current and past earnings as a guide, and to use these figures as a base in making a reasonable estimate of future earnings. If there have been reasonably normal business conditions for a period of years, the average of the earnings over the period may afford a better index of earning power than the current figure alone.”
- Maintenance and depreciation may under- or overstate earnings.
- Average earnings over several years should easily cover interest and dividend payments.
- Be aware of companies showing a trend in improved earnings. “However, before purchasing a common stock because of its favorable trend it is well to ask two questions: (a) How certain am I that this favorable trend will continue, and (b) How large a price am I paying in advance for the expected continuance of the trend?”
- “The price of common stocks will depend…not so much on past or current earnings in themselves as upon what the security buying public thinks the future earnings will be… In the ordinary case the price of a common stock is the resultant of the many estimates of what the earnings are going to be in the next six months, in the next year, or even further in the future. Some of these estimates may be entirely incorrect and some may be exceedingly accurate; but the buying and selling by the many people who make these various estimates is what mainly determines the present price of a stock.”
- Future earnings estimates explain why two stocks with similar earnings per share can trade at vastly different P/E ratios. A low P/E stock has a low expected earnings growth priced in while a high P/E stock reflects a high expected earnings growth.
- “When neither boom nor deep depression is affecting the market, the judgment of the public on individual issues, as indicated by market prices, is usually quite good. If the market price of some issue appears out of line with the facts and figures available, it will often be found later that the price is discounting future developments not then apparent on the surface. There is, however, a frequent tendency on the part of the stock market to exaggerate the significance of changes in earnings both in a favorable and unfavorable direction.”
- Investing is both Quantitative and Qualitative: “At bottom the ability to buy securities — particularly common stocks — successfully is the ability to look ahead accurately. Looking backward, however carefully, will not suffice, and may do more harm than good. Common stock selection is a difficult art — naturally, since it offers large rewards for success. It requires a skillful mental balance between facts of the past and the possibilities of the future.”
- “The investor who buys securities when the market price looks cheap on the basis of the company’s statements, and sells them when they look high on this same basis, probably will not make spectacular profits. But on the other hand, he will probably avoid equally spectacular and more frequent losses. He should have a better than average chance of obtaining satisfactory results. And this is the chief objective of intelligent investing.”
Buy the Book: Print