This book was published around 1937 by investing legend Ben Graham. Ben is also regarded as the guy under whom the great Warren Buffett started his investing journey. The book teaches financial statement analysis in a very simple manner. It also focuses on key relationship between P&L, Balance Sheet and Cash flow statements of a company. Also critical analytics ratios in a practical way are covered in this book.
Please find our notes below:
Balance sheet shows how much a company owns (assets) and owes (liabilities) at a particular point in time mostly prepared on a semi-annual and annual basis.
Assets = Tangible (plants, property, equipment, inventories, accounts receivable, cash) + intangible Assets (trademark, lease rights, goodwill)
Liabilities = Short term debt (accounts payable, current portion of long term debt, advances from customers) + Long term Debt (bank loans, bonds, lease liability)
Tangible assets are written down through depreciation & intangible assets are written down through either amortization or impairment.
Depreciation & amortization/depletion means a normal wearing out assets over its typical lifespan. It allows the cost of the asset to be charged off ( in the income statement) over a number of years.
Depletion gets applied in commodity businesses like cement, mining, crude oil
Special term for companies doing big asset/goodwill write-off: “watered stock” - As they inflated their asset value leading to inflated book value, which was later written off as one time charges against earnings/profits.
True value of a company’s assets may be entirely different from the balance sheet total.
A company’s size/scale is measured by its assets size or revenues by comparing to the other companies in the industry (peer group).
It is not so essential to invest only in companies with dominant size, as countless examples of smaller companies prospering more than larger ones can be seen in the markets. After all, today's large companies were also small caps many years ago.
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 Current liabilities are debts incurred during normal business operations/current portion of long term debts to be paid or maturing within one year.
Current Ratio = current assets/current liabilities. A high ratio indicates company will easily meet short-term obligations/payouts.
Working capital = current assets – current liabilities. Working Capital makes it easier for a company to run daily operations 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.
Quick Ratio = (Current Assets – Inventory)/Current Liabilities
Inventory: Ratio to track is turnover. inventory Turnover = Revenues/average inventory. Inventory turnover can be compared on a year to year basis. Measures how efficiently the company turns inventories into profits.
Receivables/debtors: A large ratio of receivables/sales means the company may be at a higher risk of loss if due by unpaid account does not come on time. increasing trend is a problem. Also, watch for companies that allow long-term payment options in such scenario debtor/revenue ratio will be comparatively high naturally.
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.
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 (payable/Revenue ratio & payable/profit ratio) , then its a sign of weakness. Exception being if still our payable days are much below industry standard.
Direct Losses reported in equity: 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. The investors should be particularly careful not to exaggerate the significance of a single year’s earnings.
Book value attempts to show the liquidation value of all the tangible assets, but in reality, the true liquidation value can be less than book value. As sometimes inventory and fixed assets are likely to be sold at a significant loss due to urgency.
Book value actually measures not what the shareholder will get out of the business if liquidated but rather what they have invested into the business (including retained earnings).
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.
Valuing companies on book value is majorly applied in banks, insurance companies, and investment holding companies
Earning Power of a company = Expected earnings in the future
We take current & past earnings as a guide to predict future earnings. PLEASE NOTE: If there have been reasonably normal business conditions for a period of years in the past, the average of the earnings over the period may afford a better index of earning power than the current figure alone.”
Depreciation numbers can be manipulated to overstate or understate earnings. Check Volatility in year-on-Year depreciation rates of a company.
Future Trends Vs Past Trends: 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?”
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.
Excellent quote on Market behavior: "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 requires balance between facts of the past and possibilities of the future.
Buying & selling securities due to over-valuation or undervaluation based on reported financials ONLY will not allow you to make spectacular returns but also will be save you from big losses. Market is a future discounting machine.
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