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.