Benjamin Graham, about valuation, capitalization factor and about making analyzes

After a lot of work and research into the company, the analyst has reached a situation where he needs to determine the true value of the company. For the valuation of companies that are growing their profits, Graham used the capitalization factor. To determine it, the analyst examines the general long-term outlook. This is influenced by the company's internal future prospects and the prospects of its business sectors. It is also influenced by the competence of the management, which is always a slightly biased view, the financial situation and dividend history, and the level of dividends.

The capitalization factor is difficult to determine if there are continuous changes in the business and management. In this case, the investor must take them into account in the margin of safety. The capitalization factor can really only be used for companies that are growing profits. The formula for valuation according to Graham is:

Value = earnings per share x (8.5+2* profit growth rate percent)

Note! Earnings per share are adjusted for non-recurring items. This is important to remember, because the growth rate percentage comes without the effect of non-recurring items. The size of interest rates also has an effect. The formula does not take into account future interest rates, because they are impossible to predict. It is simple because Graham did not come up with a better alternative. It does not take into account alternative interest rates that affect the present value of results. A sufficient margin of safety helps reduce the inaccuracies produced by using the capitalization factor.

In addition to the capitalization factor, Graham used balance sheet valuation for valuation. This method usually applied to companies that did not grow their results evenly or made losses from time to time. He conservatively added up the values ​​of the assets and thus obtained a value for the company. He determined the value only for tangible assets, such as factories, machinery, land, inventory, etc.

Three obstacles to using analysis

1. Insufficient or incorrect information

2. Uncertainties about the future

3. Unreasonable market behavior

Intentional falsification of information is rare. Misunderstandings often result from accounting tricks or from failure to assess the qualifications of qualitative analysis components, such as managers. Withholding information is less common, because the regulations on disclosure are strict. More often than not, unsavory information can be found in the footnotes or on the last pages of press releases. Graham recommends that you read both carefully. In addition, you should interpret management's speeches independently and not just believe them. If the management has a long history in the company, one must check the track record of speeches to the history of a company.

Predicting the future is difficult. The uncertainty of assessing it creates the biggest problem. The conclusions drawn from the analysis may be outdated when new information comes to light. Analysis of the future must be made on the basis that past events provide a rough guide to the future. The more questionable the assumption is, the less useful the analysis will be.

Market prices should not influence. The market can move prices much higher than the value for a long time. Prices do not directly affect the conclusions, but rather the benefits derived from them. If price remains overvalued for a long time, the investor will not be able to buy the investment at the desired price until the factors affecting the conclusions change. In this case, the analysis must be at least partially redone by adapting to the new situation.

Generally about analysis

Even a single analysis requires a huge amount of work. Analyses do not require higher mathematics or difficult calculations. Using them should serve as a warning signal to you if someone offers help and provides difficult mathematical formulas as explanations. The use of compound interest, the average, percentages, multiplication and division, and addition or subtraction is enough. Mathematics is supposed to give accurate and reliable results, but in the stock market these rules do not apply. Valuation is imprecise at best. Graham worked in the market for decades and, according to his words, never saw reliable analysis of stock values, other than using simple calculations.

The number of companies to be analyzed and the amount of work used can be reduced by creating precise preconditions for the companies under review. If the companies do not meet them, they can be left out of the analysis or the analysis can be stopped. I currently only study Finnish companies, so I am rarely in a situation where I need to analyze companies in more detail. When investing in companies on larger stock exchanges, I have to analyze larger volumes. In this case, it is even more important that the investor has defined the prerequisites for the companies he wants to value. There are many tools available that reduce the workload. There are several stock screeners on the market that look for stocks that meet the prerequisites.

You cannot skip your homework, i.e., analysis, if you want to make decisions about investments. Help from others can cause more problems than is useful. The only way to skip work is to invest in cost-effective index funds with time diversification. The first ones were founded around the time of Graham's death in the mid-1970s, so he did not have time to recommend them. Graham divides investors into those who are willing to do their work and those who are not. In the latter case, the risks increase too much. In this case, the only right way to invest is index funds.

Analyzing is a skill that cannot be learned without practice. There are no shortcuts to learning, so you must practice. Not all companies are analyzed the same way. You have to learn to understand how to analyze, for example, banks and consumer goods companies. Another option is to decide in advance which companies to focus on. If you do not know the industry well enough, you do not need to analyze the related business. Thinking about this in advance reduces workload.

Even the most careful analysis can be wrong, and even the best analysts make mistakes. Therefore, you should always consider the probability of being right. Focus on the following questions:

• How much have I practiced?

• What is the track record of my previous analyses?

• What is the typical success rate of other analysts?

The importance of doing analysis can be summed up in one sentence: If you can't determine the value of an investment with reasonable accuracy, you shouldn't invest in it. Every top investor does this or can determine that the value of an investment is clearly higher than the price. This is the most usual case for stocks. The analysis for other assets might have better possibilities to be right. There are no shortcuts, and listening to others will most likely lead to greater losses. 

Benjamin Graham: Comparing companies in the same industry

 In addition to examining a single company, the analysis should always include a comparison of several companies in the same industry. Quantitative analysis does not tell the whole story. In addition, qualitative analysis must be performed. The goal is not only to compare companies with each other. Examining companies in the same industry also tells about the opportunities offered by the industry. The end result may reveal that the business sector does not offer any company reasonable opportunities for long-term investments. Sometimes the analysis also offers a better investment target in the industry than the original company analyzed.

Entire business cycles offer the most reasonable time frame to examine. Usually, the length of a cycle varies from five to ten years. Using longer cycles can be a waste of time. Quantitative and qualitative analysis may require different time frames. It is difficult to assess the impact of management levels on the success of companies if there have been significant changes in the management of one of the companies being compared. This also applies to major changes in the business, i.e. large acquisitions or asset sales, which can make it difficult to make useful comparisons. All one-time items for companies should also be removed.

Graham thought that analysis should provide at least the following information when comparing companies:

• Price

• Number of shares

• Market value

• Debt

• Book value / Sales

• Profit margin

• Last earnings per share

• First earnings per share for the period under review

• Average earnings per share

• P/E ratio

• P/S ratio

• Dividend rate

• ROE

• Current ratio

• Tangible assets / debt

• Average EPS growth rate

• Average dividend payout ratio

• Number of tangible assets / market value

• Ratio of possible preferred shares or bonds to market value

• Possible special figures due to business sectors

Graham considered the P/E ratio to be the most important. Next comes the P/S ratio. Graham considered a P/E ratio higher than the average for the business sector to be a risk factor. According to Graham, when the market value is much lower than the turnover, the company has a good chance of improving results sharply as the general outlook for companies in the industry improves. Graham did not consider balance sheet comparisons to be significant factors when comparing companies if they did not show clear deviations, either in a good or bad direction. Graham left the significance of current results, average results and the profit trend to each investor to decide for himself. He focused most on the averages.

The final results of company comparisons mainly tell about the past, like other analyses. Therefore, you should remember that the company that did best in the past is not automatically a better performer in the future. This is more likely, but does not directly tell which company is the best investment target. It is easier to come to this conclusion if the companies operate in approximately the same geographical locations and sell almost identical products and services. This is the case when qualitative factors confirm the final results of the quantitative comparison.

Benjamin Graham Balance Sheet analysis part 3

It is easier to use the balance sheet to find weaknesses in a company's financial situation than strengths. The analyst must find evidence of the company's cash sufficiency on the balance sheet, whether the company has enough assets to cover its liabilities, or whether the company is in a situation where its debts are maturing. The balance sheet must provide evidence that the company has sufficient debt service capacity.

The assets found on the balance sheet has to be twice the amount of liabilities according to Graham. This value is not absolute. The company must be examined as a whole. Do not reject an investment based on this ratio alone, but also look at the result, for example. Sometimes the ratio should be at least three. Graham also measured the strength of the company's financial situation with the Quick ratio, which he called the acid test. In it, the company's current balance sheet value, excluding assets, should be at least equal to the amount of liabilities. If both tests are not passed, Graham said that the company's finances were not in sufficient condition. The tests also apply to the purchase of the company's bonds and preferred shares.

Financial difficulties in companies usually come from the maturing of bank loans or other short-term loans. These are not always signs of a company's poor financial situation. A reasonable amount of debt can act as leverage in increasing returns. In this situation, the analyst needs to investigate the situation further. The situation is rarely critical when the company is making a profit. The borrower also matters. The debt of a subsidiary or the short-term loan it provides to the company is not as critical to the financial situation as external financing. The greatest threats are large bonds that are maturing in the near future. Large debts that mature in the medium term can also become problems if the company's results are poor, so the investor must also assess their solvency.

Changes in balance sheet values ​​must also be studied in the long term. There are three aspects to the study.

1. Check whether the reported results are correct 

2. Determine what effects losses or profits have had on the financial situation

3. Investigate the connections between the ability to make a profit and the resources found on the balance sheet in the long term

The reported results are not always correct. In Graham's examples, distortion was made, for example, by taking assets from previously made surpluses into the balance sheet and not reporting these changes in the income statement. I do not know the laws well enough to say whether this is still possible. There are certainly other ways. Not all profits and losses are of the same value. For example, losses in inventory values ​​do not automatically weaken the balance sheet. Therefore, the reasons for companies' results should always be sought in the balance sheet.

It is worth examining the connection between the ability to make a profit and the resources found on the balance sheet over a longer period of time, but even then one should not go to extremes. The optimal period of examination is the length of an entire cycle. Sometimes it is difficult to know where a company is in the cycle, so the analyst may have to study the entire previous cycle and the current cycle up to the present day. In this case, the review period can be 5-15 years. The normal cycle is five to ten years. In the worst case, exceptional events, such as a major war, increase the review period. In this case, the changes in the balance sheet and profit-making ability from the previous cycle may be exceptional. In this case, the length of the review period may increase. Most often, the analysis has been completed long before this operation, so there is no need to be intimidated by the amount of work.

Benjamin Graham Balance sheet research part 2

Lesson 9 Balance sheet part 2

Current ratio was the most important figure for Graham, at least when he published the book Security Analysis. It measures the liquidity and financial buffers. He thought this ratio was a reasonably accurate view of how much money could the owners get by liquidating the company. There are three possible reasons and their combinations why the market cap is less than the possible liquidating value:

1. The price that market offers is too low
2. The company´s directors have made serious mistakes.
3. The owners have a wrong attitude toward there assets.

You should remember that debts are real and the value of assets has to be disputed. You also have to remember that there is no possibility to define the exact liquidation value. This value needs to be compared with the price the market is offering. If your valuation is close to the market price, you can´t make any conclusions. The liquidation is in the best use in the situation where the company or some of it´s parts need to be liquidated. When the company has economic difficulties, the most productive parts of the company will be sold in fraction of their real value. When there is no such need, the liquidation values are much higher.

Graham had some simple ways of valuing the company assets:

• Cash, cash equivalents and marketable securities 100% of book value
• Receivables 75-90%, approximately 80% on average
• Inventories 50-75%, approximately 2/3 on average
• Others like real estate, intangible assets, and machinery, 1-50%, 15% on average

Of course, these are just approximate numbers, but it is better to be roughly right than completely wrong. Getting these numbers is more an art than science, except the cash and marketable securities part of valuation. These numbers also depend on the industry. The values of Inventories in the electronics industry become obsolete very fast compared to some other industries. And the inventories of the oil refineries can become more expensive, when oil prices increases. Machinery can also become worthless before all the depreciation has affected the assets in the assets. Intangible assets are hard to evaluate. Sometimes brands are much more valuable than what is their worth in the assets. You can find more exact information from the Graham´s book Security Analysis.

It is hard to find businesses that has undervalued assets in modern days. Most undervaluations come from intangible assets and their values are hard to define. Most often, companies with undervalued assets are found after a longer decline of the market prices. Graham thought you should sell the business, if the price in the markets has been a lot more lower than the liquidation value. In this case, you should ask yourself that is there any basis for keeping a company public or what should the directors do to correct the undervaluation. This can happen in three ways of a combination of them:

1. Improving the earnings power. It can happen through the improvement of the business conditions of the industry or changing the business into more productive by having new directors or trusting the current ones. It is most probable that new directors can achieve this change.
2. Through mergers or acquisitions. Directors of the other company might have better chances to change the business into better direction. There can also have some synergies by having a bigger business.
3. A public offer for the company or for its parts

Stock price that is well below the liquidation value of the company doesn´t automatically mean that you should buy the stock of an individual company. Instead of buying individuals stocks, Graham recommended to buy a diversified portfolio in which all the stocks are bought below liquidation values. It is clear that not all these kind of stocks are worth buying. They won´t fulfill all the expectations. As an investor, you are still pretty much in the safe place, because you shouldn´t be too worried about losing all your money. Graham also mentioned that you should still be sure to do your homework before buying. These companies should have shown so much earnings power in the past compared to market price today that they are not destroying the assets in the balance sheet. For some reason Graham had an image that these companies were the most successful, when the market prices weren´t in their highs or lows.

I hope you can find some time to think about Graham´s simple ways of valuing the company assets. Do you find them applicable in today´s world?

-TT

Benjamin Graham Lesson 8 Balance sheet research

The balance sheet tells you about the assets and liabilities of the company at some point of time. It can also show how it has changed over a period of time. You should evaluate it critically. Graham says you should accept the company´s figures about liabilities. The real value of the assets can be different than company has announced. The value of some fixed assets, such as inventories are not always the same as found from the balance sheet. Some of them can have the same value company paid for them even though they are worthless. Intangible assets such as, mental capital of the employees and brand value are hard to evaluate. They can be either much undervalued or overvalued. Most often they are overvalued. You have to use your own judgment about the worth of such assets.

As an analyst, you will benefit at least in four ways. First, you can define the character and the amount of the resources that are used in a business. These resources are the basis of the earnings in the economically survivable business. A business without proper resources cannot have any significant earnings in a competitive industry. You can also use the balance sheet to find out how much an owner of a business can get from the liquidation of the company´s assets, when the business is not survivable.

Second, you can also use the resources in the balance sheet to figure out the character and stability of the company´s sources of income. Graham thought that the return of assets can only seldom create more income than the cost of capital. He believed that earnings estimates that are only supported by the balance sheet are realistic and accurate enough. The earnings of the business are short-lived unless the balance sheet support them. Graham believed that bigger profit margins were tempting for new competitors without a need for a strong balance sheet.

Third, the liabilities tell an analyst about the sources of financing and economical situation. The large amount of recurring debt or nonrecurring debt that needs to be paid in few years refers to coming financial problems. Even small variations can lead to a significant losses of enterprise value. Fourth, the changes in the balance sheet tells you about the quality of the earnings.

Cash flows should reflect on the changes in economic situations in the companies. You have to remember that balance sheet tells you the situation about the assets and liabilities right now. Without following the changes in the balance sheet, you cannot evaluate the development of the business and how it should happen in the future.

You can make an estimation about the value of the balance sheet in many ways. Graham had three different ways of doing it. He used a book value, a quick ratio, and current ratio. Graham defined a book value by adding all the fixed assets together and subtracts them with all the liabilities, preferred stocks, and their liabilities. Quick ratio adds up the cash and cash equivalents, and divide them with all the liabilities and preferred stocks. Cash includes all the marketable securities, etc. Current ratio adds up all the current assets and divides them with current liabilities.

Graham had mixed attitudes toward the book value during his investment career. He first ignored the book value in a book Security Analysis, because he thought that companies reported flawed estimated about the values of the assets in the balance sheet. On the other hand, he uses book values later in his career, when he was trying to find right securities for his diversified portfolio. He also believed that you should check the book value if you are interested about the stock of a company and want to make an estimation how much you should pay for it. You should never take a company´s valuation by itself. You have to know Quick ratio for a stock is seldom larger than how much you have to pay for it in the markets. These situations can be valuable for the investor, unless a company has large losses.

I hope you will find time to search through a balance sheet of a company for the last business cycle. You should find out how assets and liabilities have progressed through the cycle. Then make your own conclusions about them. For example find out if they have any discontinuities? If so, why?

-TT

Benjamin Graham, Lesson 7 Earnings trends

There are at least two dangers in using earnings trends. First danger is that they can be deceitful. Second danger is that you can use a trend to justify any value for the stock by assuming that it continues forever. You can get an insane value for the stock by assuming that a large earnings growth works for your advantage for decades. Using an average growth rate from the past do not tell much about the future. Especially, when the past has been very favorable for the business.

Earnings trend can be rising, declining, stable, or volatile. A stable trend does not have a large variation compared to the average growth in any single year. Graham used averages on the top and the bottom of the business cycle. When he evaluated the earnings trend he used the average of the last three years with corresponding figures ten years earlier. For example, average earnings from 2015-2017 compared to average earnings of 2005-2007. Using only the bottom of the cycle and compare that figure to the top of the cycle can give you an inflated number.

Rising earnings trend has some common enemies like harder competition, regulations, and the law of large numbers. No business can grow forever. The bigger the business, the harder it gets to maintain a rising earnings trend. As an analyst, you have to figure out why and how the business can have a rising earnings trend by overcoming the obstacles in its path. Is it because of new products, great management, etc? You should never think that rising earnings trend is maintainable for many business cycles in the future. The error rates of the evaluations stay manageable and you can justify your evaluations with a higher probability of being right. You should also be sure that you are not evaluating an earnings trend by the basis of abnormal business conditions. It doesn´t matter if these conditions happened in the past or are happening right now. You should always evaluate the business in normal conditions and you should ignore all the nonrecurring items.

Declining earnings trend needs different way of thinking than rising earnings trend. Graham recommends thinking the earnings trend by checking the expectations and some qualitative factors of the business. You cannot deal with the average earnings or the earnings trend from the longer time period. You cannot make an assumption that business will go bankrupt because of the declining earnings trend. Changes will be probably made after a period of decline. If you have a stable earnings trend, you should think about the durability of this trend. If this is the case, you can use an average earnings to evaluate the future earnings. A volatile earnings trend can give an edge for a competent analyst. It is more probable that markets are wrong in these cases. Some of the market participants forget these businesses. And you should do the same if you have no edge.

Graham didn´t exclude any businesses depending on the earnings trends. Trends do not mean any short-term changes in the businesses like nonrecurring items or fast declines or rises in the general business cycles. They are not significant, when trends are clear. Sudden earnings declines can offer some valuable opportunities for smart investors. You have to accept cyclical variations in earnings. If you are evaluating a rising earnings trend you have to see that earnings in the bottom of this cycle has to be bigger than in the last one. And the earnings on the top of the present cycle should be bigger than on the top of the last cycle. You should also never pay too much for the rising earnings trend. Expected earnings growth can be too large. Graham says that annual earnings growth should not be higher than ten per cent in the long run.

I hope you will find time to check some companies´ earnings statements for their business cycles and see how their earnings look like through the cycle. Then make your own conclusions if their trends will continue or are there possible trend changes happening.

-TT

Benjamin Graham Lesson 6 analysing earnings statement

You cannot only focus on the earnings statement and forget the balance sheet while you are analysing the earnings power of the company. Earnings statements change faster than the balance sheet. When you do it that way, the method of evaluating the real value of the earnings power varies more. It is easier to come to wrong conclusion about the real earnings power of the business. You will get a better evaluation by using the changes in the balance sheet to confirm the earnings statement. Checking the changes in the balance sheet in the long run produces better picture of the reality of the business.

Graham divides the analysis of the earnings to three different perspectives:

1. Accounting perspective: What are the real earnings in the period you are checking?
2. Business perspective: What signs of the earnings power of the future can be found from the earnings statement?
3. Financing perspective: What parts of the earnings statement you should take into consideration and what standards you should follow to get a realistic picture about the real value of the stocks?

You should forget the one time earnings when you are trying to find the real earnings of the year. These one time earnings are selling your assets, deferred taxes and the changes in the intangible assets like goodwill. These things do not tell much about the earnings power of the future. Most often, they just distort the conclusions of the analysis. You should also think about the real value of the subsidiaries´ depreciation and earnings. Consider their value for the company yourself. They can be over- or undervalued in the earnings report.

You can evaluate the earnings power of the future from the past earnings statements, including the last one. It doesn´t really mean that you should expect that everything will continue the same as before. Analyzing the past is the least satisfying part of the analysis. It can nevertheless be the most important part. In most cases, you cannot rely on the past in the future. The speed of change is accelerating in many businesses. You have to evaluate the earnings power in the long run. The most important factors for Graham were:

1. Physical volume
2. Unit price
3. Unit cost
4. Taxes

An analyst has to evaluate them. The result of the analysis cannot be very accurate. It only gives a direction where the business might be going. You should think about the range, not the accurate number. The list is pretty short. It does not give you all the details about the business. It can give you an illusion of being right. Sometimes simple ways are better. Single earnings statement is not enough to give you a reliable conclusion about the business. It can be usable if it gives you enough proofs about the future. Graham said that you can use a single earnings report if it fulfills the next conditions: The earnings report was not exceptional, business has shown an increasing trend for many years and the analyst is convinced that business is in the growing industry. This can give him a proof of a continuing trend in the industry and business.

Graham believed that the longer inspection period should have been something between five and ten years. He used the averages of from five to ten years. He changed his opinions throughout his career. The better way to think about the period is trying to figure out the business cycle of the industry and the business. If you happen to use the time period which is from the bottom of the business cycle to the top, average earnings growth can give you an inflated result. You have to remember that not all the businesses have the same business cycles in the same industry. And they can have more variation in the different industries. You also have to remember that business cycles are not always easy to figure out. Sometimes it is even impossible.

It is easier to forecast the business cycles of the industries than individual companies. The advantages of using the long period is balancing out the effects of the business cycles and making it easier to evaluate the continuation of the earnings trend. Sometimes there are dying industries and businesses and it is not always easy to figure out them on time. Fast changes make forecasting impossible. You have to take this into consideration, when you see great changes happening in the industry or business you are analysing. Sometimes it is better to find easier businesses to analyse and forget the hard ones.

Homework: Try to find a company and figure out the length of its business cycle. Then find out the earnings during the cycle for the company. Then, go through the earnings statements and look for any non-recurring items. See how much the real earnings are for the business cycle and compare this figure with the first one. Then, check the reasons for the non-recurring items. Are they one time only losses or profits or are they normal for the company? Has it done many restructurings of the business or mass-layoffs? Mass-layoffs are signs of poor management or complete changes in the business environment. Continual restructurings can also tell you about poor cost management in the company or management´s poor ability to understand the business.

Have a nice end of the week!

-TT