Security Analysis by Benjamin Graham is probably the bible for value investors around the world. The principles explained in the book are still applicable in today’s investors. But it will be a good learning experience to find relevant examples in recent times of the concepts explained in the book. I intend to write my understanding of the concepts. I would appreciate comments, examples, and experiences on the same. It will clear our own concepts of value investing. I hope it will be a good experience. Let me directly jump to the equity investments where Graham talks about the analysis of income accounts. It is chapter 31 in the book.
Before going into the details of the income account Graham discusses how most investors approaches earnings power of a company wrongly. Investor should study balance sheet in addition to operating results. He asserts that the sole emphasis on earning power has some disadvantages. Looking at the balance sheet provides him a twofold litmus test of the value of the business- earnings and assets. Earnings are subject to more rapid changes. So the stock values will have more instability than present. He emphasizes more on the last disadvantage of misrepresentation of the earnings.
Wall Street’s method of appraising common stocks is very simple. They find the earnings of the stock and multiply by suitable factor which reflects many parameters. As earnings are subject to arbitrary determination, it is quite likely that this approach brings in some arbitrary factor in which is not a sound way of analyzing a business. Security analyst should scrutinize the publicized earnings per share. Author makes one solid procedure to study income account-
1) Accounting aspect- What are the true earnings for the period?
2) Business aspect- What indications earnings carry to the future earnings?
3) Investment finance aspect-Which elements of earnings exhibit should be taken into account?
Rest of the chapter discusses how earnings can be misstated. Major way of doing this is by including nonrecurring profits to earnings. Ideally such profits should be credited to the surplus rather than earnings, as they are not part of the operating earnings. Some examples of such profits are profit or loss on sale of fixed assets, securities, retirement of capital obligation at discount or premium, gain or loss as a result of litigation. Graham discusses 3 important nonrecurrent items.
Profits and losses on sales of fixed assets should be charged against surplus rather than earnings. Examples of this type of misrepresentation are report of Manhattan Electric Supply Company in 1926 and United States Steel Corporation in 1931. In case of Manhattan, earnings per share reduced from $ 10.25 to $ 3.40 due to sale of its battery business. Steel company managed to convert a loss of $ 6.3 million to a profit of $ 13 million due to inclusion of the profit of sale of property.
Profits from the sale of marketable securities should be treated in a similar way. They shouldn’t be included in earnings. Example would be National Transit Company in 1928. It managed to increase the earnings per share from $ 1.24 in 1927 to $ 2.34 in 1928. Most of the increase was accounted by the profit on the sale of securities which amounted exactly the increase. So in reality company showed no increase in the earnings.
Investment trusts throw special situation in this regard. It is their primary business to sell the securities. So the study of such companies should include three aspects: investment income, profit and loss on the sale of securities and change in market values. Neither earnings in one year nor an average of earnings over a period have any significance over future earnings unless it is compared against a general market performance. If market performs well there are chances that company will do well. But it is in no way an indication of superior management. Market generally reacts to the one-year earnings of Investment Company. If this one-year is in bullish market, it might be a wrong impression. Analyst should try to discourage an ordinary investor from investing in such companies because it requires lot of financial experience and shrewd judgment.
Profits through purchase of securities at discounts not only distort earnings but also show the attitude of the management towards shareholders. The profits are at the expense of shareholders. Example of such malpractice would be Utah Securities Corporation which purchased its own obligation. Had it not done that, it would not have been able to cover its interest expense. Opposite result would appear if securities were purchased at a premium. But such losses are charged to surplus not against income.
Before going into the details of the income account Graham discusses how most investors approaches earnings power of a company wrongly. Investor should study balance sheet in addition to operating results. He asserts that the sole emphasis on earning power has some disadvantages. Looking at the balance sheet provides him a twofold litmus test of the value of the business- earnings and assets. Earnings are subject to more rapid changes. So the stock values will have more instability than present. He emphasizes more on the last disadvantage of misrepresentation of the earnings.
Wall Street’s method of appraising common stocks is very simple. They find the earnings of the stock and multiply by suitable factor which reflects many parameters. As earnings are subject to arbitrary determination, it is quite likely that this approach brings in some arbitrary factor in which is not a sound way of analyzing a business. Security analyst should scrutinize the publicized earnings per share. Author makes one solid procedure to study income account-
1) Accounting aspect- What are the true earnings for the period?
2) Business aspect- What indications earnings carry to the future earnings?
3) Investment finance aspect-Which elements of earnings exhibit should be taken into account?
Rest of the chapter discusses how earnings can be misstated. Major way of doing this is by including nonrecurring profits to earnings. Ideally such profits should be credited to the surplus rather than earnings, as they are not part of the operating earnings. Some examples of such profits are profit or loss on sale of fixed assets, securities, retirement of capital obligation at discount or premium, gain or loss as a result of litigation. Graham discusses 3 important nonrecurrent items.
Profits and losses on sales of fixed assets should be charged against surplus rather than earnings. Examples of this type of misrepresentation are report of Manhattan Electric Supply Company in 1926 and United States Steel Corporation in 1931. In case of Manhattan, earnings per share reduced from $ 10.25 to $ 3.40 due to sale of its battery business. Steel company managed to convert a loss of $ 6.3 million to a profit of $ 13 million due to inclusion of the profit of sale of property.
Profits from the sale of marketable securities should be treated in a similar way. They shouldn’t be included in earnings. Example would be National Transit Company in 1928. It managed to increase the earnings per share from $ 1.24 in 1927 to $ 2.34 in 1928. Most of the increase was accounted by the profit on the sale of securities which amounted exactly the increase. So in reality company showed no increase in the earnings.
Investment trusts throw special situation in this regard. It is their primary business to sell the securities. So the study of such companies should include three aspects: investment income, profit and loss on the sale of securities and change in market values. Neither earnings in one year nor an average of earnings over a period have any significance over future earnings unless it is compared against a general market performance. If market performs well there are chances that company will do well. But it is in no way an indication of superior management. Market generally reacts to the one-year earnings of Investment Company. If this one-year is in bullish market, it might be a wrong impression. Analyst should try to discourage an ordinary investor from investing in such companies because it requires lot of financial experience and shrewd judgment.
Profits through purchase of securities at discounts not only distort earnings but also show the attitude of the management towards shareholders. The profits are at the expense of shareholders. Example of such malpractice would be Utah Securities Corporation which purchased its own obligation. Had it not done that, it would not have been able to cover its interest expense. Opposite result would appear if securities were purchased at a premium. But such losses are charged to surplus not against income.
