Intrinsic Value versus Price by Benjamin Graham and David Dodd

 

All the passages below are taken from the book, “Security Analysis” the 6th Edition by Benjamin Graham and David Dodd.

 

http://www.paulasset.com/articles/wp-content/uploads/2012/09/Benjamin-Graham_-David-Dodd-Security-Analysis-Sixth-Edition_-Foreword-by-Warren-Buffett.pdf

 

Scope and Limitations of Security Analysis.

The Concept of Intrinsic Value

 

ANALYSIS CONNOTES the careful study of available facts with the attempt to draw conclusions there-from based on established principles and sound logic. It is part of the scientific method. But in applying analysis to the field of securities we encounter the serious obstacle that investment is by nature not an exact science. The same is true, however, of law and medicine, for here also both individual skill (art) and chance are important factors in determining success or failure. Nevertheless, in these professions analysis is not only useful but indispensable, so that the same should probably be true in the field of investment and possibly in that of speculation.

In the last three decades the prestige of security analysis in Wall Street has experienced both a brilliant rise and an ignominious fall—a history related but by no means parallel to the course of stock prices. The advance of security analysis proceeded uninterruptedly until about 1927, covering a long period in which increasing attention was paid on all sides to financial reports and statistical data. But the “new era” commencing in 1927 involved at bottom the abandonment of the analytical approach; and while emphasis was still seemingly placed on facts and figures, these were manipulated by a sort of pseudo-analysis to support the delusions of the period. The market collapse in October 1929 was no surprise to such analysts as had kept their heads, but the extent of the business collapse which later developed, with its devastating effects on established earning power, again threw their calculations out of gear. Hence the ultimate result was that serious analysis suffered a double discrediting: the first—prior to the crash—due to the persistence of imaginary values, and the second—after the crash—due to the disappearance of real values.

The experiences of 1927–1933 were of so extraordinary a character that they scarcely provide a valid criterion for judging the usefulness of security analysis. As to the years since 1933, there is perhaps room for a difference of opinion. In the field of bonds and preferred stocks, we believe that sound principles of selection and rejection have justified themselves quite well. In the common-stock arena the partialities of the market have tended to confound the conservative viewpoint, and conversely many issues appearing cheap under analysis have given a disappointing performance. On the other hand, the analytical approach would have given strong grounds for believing representative stock prices to be too high in early 1937 and too low a year later.

 

THREE FUNCTIONS OF ANALYSIS:

1.    DESCRIPTIVE FUNCTION

The functions of security analysis may be described under three headings: descriptive, selective, and critical. In its more obvious form, descriptive analysis consists of marshalling the important facts relating to an issue and presenting them in a coherent, readily intelligible manner. This function is adequately performed for the entire range of marketable corporate securities by the various manuals, the Standard Statistics and Fitch services, and others. A more penetrating type of description seeks to reveal the strong and weak points in the position of an issue, compare its exhibit with that of others of similar character, and appraise the factors which are likely to influence its future performance. Analysis of this kind is applicable to almost every corporate issue, and it may be regarded as an adjunct not only to investment but also to intelligent speculation in that it provides an organized factual basis for the application of judgment.

 

2.    THE SELECTIVE FUNCTION OF SECURITY ANALYSIS

In its selective function, security analysis goes further and expresses specific judgments of its own. It seeks to determine whether a given issue should be bought, sold, retained, or exchanged for some other. What types of securities or situations lend themselves best to this more positive activity of the analyst, and to what handicaps or limitations is it subject? It may be well to start with a group of examples of analytical judgments, which could later serve as a basis for a more general inquiry.

 

Examples of Analytical Judgments.

In 1928 the public was offered a large issue of 6% noncumulative preferred stock of St. Louis-San Francisco Railway Company priced at 100. The record showed that in no year in the company’s history had earnings been equivalent to as much as 11/2 times the fixed charges and preferred dividends combined. The application of well-established standards of selection to the facts in this case would have led to the rejection of the issue as insufficiently protected.

A contrasting example: In June 1932 it was possible to purchase 5% bonds of Owens-Illinois Glass Company, due 1939, at 70, yielding 11% to maturity. The company’s earnings were many times the interest requirements—not only on the average but even at that time of severe depression. The bond issue was amply covered by current assets alone, and it was followed by common and preferred stock with a very large aggregate market value, taking their lowest quotations. Here, analysis would have led to the recommendation of this issue as a strongly entrenched and attractively priced investment.

Let us take an example from the field of common stocks. In 1922, prior to the boom in aviation securities, Wright Aeronautical Corporation stock was selling on the New York Stock Exchange at only $8, although it was paying a $1 dividend, had for some time been earning over $2 a share, and showed more than $8 per share in cash assets in the treasury. In this case analysis would readily have established that the intrinsic value of the issue was substantially above the market price.

Again, consider the same issue in 1928 when it had advanced to $280 per share. It was then earning at the rate of $8 per share, as against $3.77 in 1927. The dividend rate was $2; the net-asset value was less than $50 per share. A study of this picture must have shown conclusively that the market price represented for the most part the capitalization of entirely conjectural future prospects—in other words, that the intrinsic value was far less than the market quotation.

A third kind of analytical conclusion may be illustrated by a comparison of Interborough Rapid Transit Company First and Refunding 5s with the same company’s Collateral 7% Notes, when both issues were selling at the same price (say 62) in 1933. The 7% notes were clearly worth considerably more than the 5s. Each $1,000 note was secured by deposit of $1,736 face amount of 5s; the principal of the notes had matured; they were entitled either to be paid off in full or to a sale of the collateral for their benefit. The annual interest received on the collateral was equal to about $87 on each 7% note (which amount was actually being distributed to the note holders), so that the current income on the 7s was considerably greater than that on the 5s. Whatever technicalities might be invoked to prevent the note holders from asserting their contractual rights promptly and completely, it was difficult to imagine conditions under which the 7s would not be intrinsically worth considerably more than the 5s.

A more recent comparison of the same general type could have been drawn between Paramount Pictures First Convertible Preferred selling at 113 in October 1936 and the common stock concurrently selling at 157/8. The preferred stock was convertible at the holders’ option into seven times as many shares of common, and it carried accumulated dividends of about $11 per share. Obviously the preferred was cheaper than the common, since it would have to receive very substantial dividends before the common received anything, and it could also share fully in any rise of the common by reason of the conversion privilege. If a common stockholder had accepted this analysis and exchanged his shares for one-seventh as many preferred, he would soon have realized a large gain both in dividends received and in principal value.1

 

Intrinsic Value versus Price

From the foregoing examples it will be seen that the work of the securities analyst is not without concrete results of considerable practical value, and that it is applicable to a wide variety of situations. In all of these instances he appears to be concerned with the intrinsic value of the security and more particularly with the discovery of discrepancies between the intrinsic value and the market price. We must recognize, however, that intrinsic value is an elusive concept. In general terms it is understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations established by artificial manipulation or distorted by psychological excesses. But it is a great mistake to imagine that intrinsic value is as definite and as determinable as is the market price. Some time ago intrinsic value (in the case of a common stock) was thought to be about the same thing as “book value,” i.e., it was equal to the net assets of the business, fairly priced. This view of intrinsic value was quite definite, but it proved almost worthless as a practical matter because neither the average earnings nor the average market price evinced any tendency to be governed by the book value.

 

Intrinsic Value and “Earning Power.”

Hence this idea was superseded by a newer view, viz., that the intrinsic value of a business was determined by its earning power. But the phrase “earning power” must imply a fairly confident expectation of certain future results. It is not sufficient to know what the past earnings have averaged, or even that they disclose a definite line of growth or decline. There must be plausible grounds for believing that this average or this trend is a dependable guide to the future. Experience has shown only too forcibly that in many instances this is far from true. This means that the concept of “earning power,” expressed as a definite figure, and the derived concept of intrinsic value, as something equally definite and ascertainable, cannot be safely accepted as a general premise of security analysis.

Example: To make this reasoning clearer, let us consider a concrete and typical example. What would we mean by the intrinsic value of J. I. Case Company common, as analyzed, say, early in 1933? The market price was $30; the asset value per share was $176; no dividend was being paid; the average earnings for ten years had been $9.50 per share; the results for 1932 had shown a deficit of $17 per share. If we followed a customary method of appraisal, we might take the average earnings per share of common for ten years, multiply this average by ten, and arrive at an intrinsic value of $95. But let us examine the individual figures which make up this ten-year average. They are as shown in the table on page 66. The average of $9.50 is obviously nothing more than an arithmetical resultant from ten unrelated figures. It can hardly be urged that this average is in any way representative of typical conditions in the past or representative of what may be expected in the future. Hence any figure of “real” or intrinsic value derived from this average must be characterized as equally accidental or artificial.2

 

EARNINGS PER SHARE OF J.I. CASE COMMON

 

1932

$17.40(d)

1931

2.90(d)

1930

11.00

1929

20.40

1928

26.90

1927

26.00

1926

23.30

1925

15.30

1924

5.90(d)

1923

2.10(d)

Average

$9.50

 

 

(d) Deficit.

 

 

 

 

The Role of Intrinsic Value in the Work of the Analyst.

Let us try to formulate a statement of the role of intrinsic value in the work of the analyst which will reconcile the rather conflicting implications of our various examples. The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish either that the value is adequate—e.g., to protect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age or that a man is heavier than he should be without knowing his exact weight.

This statement of the case may be made clearer by a brief return to our examples. The rejection of St. Louis-San Francisco Preferred did not require an exact calculation of the intrinsic value of this railroad system. It was enough to show, very simply from the earnings record, that the margin of value above the bondholders’ and preferred stockholders’ claims was too small to assure safety. Exactly the opposite was true for the Owens-Illinois Glass 5s. In this instance, also, it would undoubtedly have been difficult to arrive at a fair valuation of the business; but it was quite easy to decide that this value in any event was far in excess of the company’s debt.

In the Wright Aeronautical example, the earlier situation presented a set of facts which demonstrated that the business was worth substantially more than $8 per share, or $1,800,000. In the later year, the facts were equally conclusive that the business did not have a reasonable value of $280 per share, or $70,000,000 in all. It would have been difficult for the analyst to determine whether Wright Aeronautical was actually worth $20 or $40 a share in 1922—or actually worth $50 or $80 in 1929. But fortunately it was not necessary to decide these points in order to conclude that the shares were attractive at $8 and unattractive, intrinsically, at $280.

The J. I. Case example illustrates the far more typical common-stock situation, in which the analyst cannot reach a dependable conclusion as to the relation of intrinsic value to market price. But even here, if the price had been low or high enough, a conclusion might have been warranted. To express the uncertainty of the picture, we might say that it was difficult to determine in early 1933 whether the intrinsic value of Case common was nearer $30 or $130. Yet if the stock had been selling at as low as $10, the analyst would undoubtedly have been justified in declaring that it was worth more than the market price.

 

Flexibility of the Concept of Intrinsic Value.

This should indicate how flexible is the concept of intrinsic value as applied to security analysis. Our notion of the intrinsic value may be more or less distinct, depending on the particular case. The degree of indistinctness may be expressed by a very hypothetical “range of approximate value,” which would grow wider as the uncertainty of the picture increased, e.g., $20 to $40 for Wright Aeronautical in 1922 as against $30 to $130 for Case in 1933. It would follow that even a very indefinite idea of the intrinsic value may still justify a conclusion if the current price falls far outside either the maximum or minimum appraisal.

 

More Definite Concept in Special Cases.

The Interborough Rapid Transit example permits a more precise line of reasoning than any of the others. Here a given market price for the 5% bonds results in a very definite valuation for the 7% notes. If it were certain that the collateral securing the notes would be acquired for and distributed to the note holders, then the mathematical relationship—viz., $1,736 of value for the 7s against $1,000 of value for the 5s—would eventually be established at this ratio in the market. But because of quasi-political complications in the picture, this normal procedure could not be expected with certainty. As a practical matter, therefore, it is not possible to say that the 7s are actually worth 74% more than the 5s, but it may be said with assurance that the 7s are worth substantially more—which is a very useful conclusion to arrive at when both issues are selling at the same price.

The Interborough issues are an example of a rather special group of situations in which analysis may reach more definite conclusions respecting intrinsic value than in the ordinary case. These situations may involve a liquidation or give rise to technical operations known as “arbitrage” or “hedging.” While, viewed in the abstract, they are probably the most satisfactory field for the analyst’s work, the fact that they are specialized in character and of infrequent occurrence makes them relatively unimportant from the broader standpoint of investment theory and practice.

 

Principal Obstacles to Success of the Analyst.

a. Inadequate or Incorrect Data. Needless to say, the analyst cannot be right all the time. Furthermore, a conclusion may be logically right but work out badly in practice. The main obstacles to the success of the analyst’s work are threefold, viz., (1) the inadequacy or incorrectness of the data, (2) the uncertainties of the future, and (3) the irrational behavior of the market. The first of these drawbacks, although serious, is the least important of the three. Deliberate falsification of the data is rare; most of the misrepresentation flows from the use of accounting artifices which it is the function of the capable analyst to detect. Concealment is more common than misstatement. But the extent of such concealment has been greatly reduced as the result of regulations, first of the New York Stock Exchange and later of the S.E.C., requiring more complete disclosure and fuller explanation of accounting practices. Where information on an important point is still withheld, the analyst’s experience and skill should lead him to note this defect and make allowance therefore—if, indeed, he may not elicit the facts by proper inquiry and pressure. In some cases, no doubt, the concealment will elude detection and give rise to an incorrect conclusion.

 

b. Uncertainties of the Future. Of much greater moment is the element of future change. A conclusion warranted by the facts and by the apparent prospects may be vitiated by new developments. This raises the question of how far it is the function of security analysis to anticipate changed conditions. We shall defer consideration of this point until our discussion of various factors entering into the processes of analysis. It is manifest, however, that future changes are largely unpredictable, and that security analysis must ordinarily proceed on the assumption that the past record affords at least a rough guide to the future. The more questionable this assumption, the less valuable is the analysis. Hence this technique is more useful when applied to senior securities (which are protected against change) than to common stocks; more useful when applied to a business of inherently stable character than to one subject to wide variations; and, finally, more useful when carried on under fairly normal general conditions than in times of great uncertainty and radical change.

 

c. The Irrational Behavior of the Market. The third handicap to security analysis is found in the market itself. In a sense the market and the future present the same kind of difficulties. Neither can be predicted or controlled by the analyst, yet his success is largely dependent upon them both. The major activities of the investment analyst may be thought to have little or no concern with market prices. His typical function is the selection of high-grade, fixed-income-bearing bonds, which upon investigation he judges to be secure as to interest and principal. The purchaser is supposed to pay no attention to their subsequent market fluctuations, but to be interested solely in the question whether the bonds will continue to be sound investments. In our opinion this traditional view of the investor’s attitude is inaccurate and somewhat hypocritical. Owners of securities, whatever their character, are interested in their market quotations. This fact is recognized by the emphasis always laid in investment practice upon marketability. If it is important that an issue be readily salable, it is still more important that it command a satisfactory price. While for obvious reasons the investor in high-grade bonds has a lesser concern with market fluctuations than has the speculator, they still have a strong psychological, if not financial, effect upon him. Even in this field, therefore, the analyst must take into account whatever influences may adversely govern the market price, as well as those which bear upon the basic safety of the issue.

In that portion of the analyst’s activities which relates to the discovery of undervalued, and possibly of overvalued securities, he is more directly concerned with market prices. For here the vindication of his judgment must be found largely in the ultimate market action of the issue. This field of analytical work may be said to rest upon a twofold assumption: first, that the market price is frequently out of line with the true value; and, second, that there is an inherent tendency for these disparities to correct themselves. As to the truth of the former statement, there can be very little doubt—even though Wall Street often speaks glibly of the “infallible judgment of the market” and asserts that “a stock is worth what you can sell it for—neither more nor less.”

 

The Hazard of Tardy Adjustment of Price Value.

The second assumption is equally true in theory, but its working out in practice is often most unsatisfactory. Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by overenthusiasm or artificial stimulants. The particular danger to the analyst is that, because of such delay, new determining factors may supervene before the market price adjusts itself to the value as he found it. In other words, by the time the price finally does reflect the value, this value may have changed considerably and the facts and reasoning on which his decision was based may no longer be applicable.

The analyst must seek to guard himself against this danger as best he can: in part, by dealing with those situations preferably which are not subject to sudden change; in part, by favoring securities in which the popular interest is keen enough to promise a fairly swift response to value elements which he is the first to recognize; in part, by tempering his activities to the general financial situation—laying more emphasis on the discovery of undervalued securities when business and market conditions are on a fairly even keel, and proceeding with greater caution in times of abnormal stress and uncertainty.

 

The Relationship of Intrinsic Value to Market Price.

The general question of the relation of intrinsic value to the market quotation may be made clearer by the following chart, which traces the various steps culminating in the market price. It will be evident from the chart that the influence of what we call analytical factors over the market price is both partial and indirect—partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions. In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.

 

RELATIONSHIP OF INTRINSIC VALUE FACTORS TO MARKET PRICE (See the table from the website above)

I.              General market factors.

II       Individual factors.

 

A. Speculative

 

 

B. Investment

1. Market     factors 2. Future value factors Attitude of public toward the issue. Bids and offers. Market price. 3. Intrinsic value factors a. Technical. b. Manipulative. c. Psychological. a. Management and reputation. b. Competitive conditions and prospects. c. Possible and probable changes in volume, price, and costs. a. Earnings. b. Dividends. c. Assets. d. Capital structure. e. Terms of the issue. f. Others. { {

 

 

ANALYSIS AND SPECULATION

It may be thought that sound analysis should produce successful results in any type of situation, including the confessedly speculative, i.e., those subject to substantial uncertainty and risk. If the selection of speculative issues is based on expert study of the companies’ position, should not this approach give the purchaser a considerable advantage? Admitting future events to be uncertain, could not the favorable and unfavorable developments be counted on to cancel out against each other, more or less, so that the initial advantage afforded by sound analysis will carry through into an eventual average profit? This is a plausible argument but a deceptive one; and its over-ready acceptance has done much to lead analysts astray. It is worth while, therefore, to detail several valid arguments against placing chief reliance upon analysis in speculative situations.

In the first place, what may be called the mechanics of speculation involves serious handicaps to the speculator, which may outweigh the benefits conferred by analytical study. These disadvantages include the payment of commissions and interest charges, the so-called “turn of the market” (meaning the spread between the bid and asked price), and, most important of all, an inherent tendency for the average loss to exceed the average profit, unless a certain technique of trading is followed, which is opposed to the analytical approach.

The second objection is that the underlying analytical factors in speculative situations are subject to swift and sudden revision. The danger, already referred to, that the intrinsic value may change before the market price reflects that value, is therefore much more serious in speculative than in investment situations. A third difficulty arises from circumstances surrounding the unknown factors, which are necessarily left out of security analysis. Theoretically these unknown factors should have an equal chance of being favorable or unfavorable, and thus they should neutralize each other in the long run. For example, it is often easy to determine by comparative analysis that one company is selling much lower than another in the same field, in relation to earnings, although both apparently have similar prospects. But it may well be that the low price for the apparently attractive issue is due to certain important unfavorable factors which, though not disclosed, are known to those identified with the company—and vice versa for the issue seemingly selling above its relative value. In speculative situations, those “on the inside” often have an advantage of this kind which nullifies the premise that good and bad changes in the picture should offset each other, and which loads the dice against the analyst working with some of the facts concealed from him.3

 

The Value of Analysis Diminishes as the Element of Chance Increases.

The final objection is based on more abstract grounds, but, nevertheless, its practical importance is very great. Even if we grant that analysis can give the speculator a mathematical advantage, it does not assure him a profit. His ventures remain hazardous; in any individual case a loss may be taken; and after the operation is concluded, it is difficult to determine whether the analyst’s contribution has been a benefit or a detriment. Hence the latter’s position in the speculative field is at best uncertain and somewhat lacking in professional dignity. It is as though the analyst and Dame Fortune were playing a duet on the speculative piano, with the fickle goddess calling all the tunes.

By another and less imaginative simile, we might more convincingly show why analysis is inherently better suited to investment than to speculative situation. (In anticipation of a more detailed inquiry in a later chapter, we have assumed throughout this chapter that investment implies expected safety and speculation connotes acknowledged risk.) In Monte Carlo the odds are weighted 19 to 18 in favor of the proprietor of the roulette wheel, so that on the average he wins one dollar out of each 37 wagered by the public. This may suggest the odds against the untrained investor or speculator. Let us assume that, through some equivalent of analysis, a roulette player is able to reverse the odds for a limited number of wagers, so that they are now 18 to 19 in his favor. If he distributes his wagers evenly over all the numbers, then whichever one turns up he is certain to win a moderate amount. This operation may be likened to an investment program based upon sound analysis and carried on under propitious general conditions.

But if the player wagers all his money on a single number, the small odds in his favor are of slight importance compared with the crucial question whether chance will elect the number he has chosen. His “analysis” will enable him to win a little more if he is lucky; it will be of no value when luck is against him. This, in slightly exaggerated form perhaps, describes the position of the analyst dealing with essentially speculative operations. Exactly the same mathematical advantage which practically assures good results in the investment field may prove entirely ineffective where luck is the overshadowing influence.

It would seem prudent, therefore, to consider analysis as an adjunct or auxiliary rather than as a guide in speculation. It is only where chance plays a subordinate role that the analyst can properly speak in an authoritative voice and accept responsibility for the results of his judgments. (61-74)

 

Notes

1. For the sequels to the six examples just given, see Appendix Note 2, p. 734 on accompanying CD

2. Between 1933 and 1939 the earnings on Case common varied between a deficit of $14.66 and profits of $19.20 per share, averaging $3.18. The price ranged between 301/2 and 1913/4, closing in 1939 at 733/4.

3. See Appendix Note 3, p. 735 on accompanying CD, for the result of a study of the market behavior of “high price-earnings ratio stocks” as compared with “low price-earnings ratio stocks.”

 

 

 

DECONSTRUCTING THE BALANCE SHEET BY BRUCE GREENWALD

The enduring value of Security Analysis rests on certain critical ideas developed by Graham and Dodd that were then, and remain, fundamental to any well-conceived investment strategy. The first of these is the distinction between “investment” and “speculation” as defined by Graham and Dodd:

 

An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative. (p. 106)

 

The critical parts of this definition are “thorough analysis” and “safety of principal and a satisfactory return.” Nothing about these requirements has changed since 1934.

A second related idea is that of focusing on the intrinsic value of a security. It is, according to Graham and Dodd,

 

that value which is justified by the facts, e.g., the assets, earnings, dividends, [and] definite prospects, as distinct, let us say, from market quotations established by market manipulation or distorted by psychological excesses. (p. 64)

 

In an ideal world, intrinsic value would be the true value of a security; in today’s language it would be the present discounted value of the expected future cash flows it generates. If these expected cash flows and an appropriate discount rate could be calculated perfectly from the available facts, then the intrinsic and true values would be the same. However, Graham and Dodd recognized that this was never possible. “Inadequate or incorrect data and [the] uncertainties of the future” meant that intrinsic value would always be “an elusive concept.”

Nevertheless, thorough investigation of intrinsic value was, in this view, central to any investment process worthy of the name. It served first of all to organize examination and use of the available information, ensuring that the relevant facts would be brought to bear and irrelevant noise ignored. Second, it would produce an appreciation of the range of uncertainty associated with any particular intrinsic value calculation. Graham and Dodd recognized that even a very imperfect intrinsic value would be useful in making investment decisions. In their words,

 

It needs only to establish that the value is adequate—e.g., to protect a bond or justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price . . . [and] the degree of indistinctness may be expressed by a very hypothetical “range of approximate value,” which would grow wider as the uncertainty of the picture increased. (pp. 66–67)

 

The purchase of securities should then be made only at prices far enough below the intrinsic value to provide a margin of safety that would offer appropriate protection against this “indistinctness” in the calculated intrinsic value. In essence, what Graham and Dodd required was that an investor, as opposed to a speculator, should know as far as possible the value of any security purchased and also the degree of uncertainty attached to that value. An investment would be made only at a price that provided a sufficient margin of safety to compensate for the uncertainty involved. As a prescription for obtaining “protection of principal and a satisfactory return,” this approach has obvious advantages over almost any conceivable alternative.

The compelling logic of these foundations is one source of the continuing relevance of Security Analysis. But the book also provides a detailed roadmap of what a “thorough analysis” looks like that is exemplary in its completeness.

With regard to common stock investments, Graham and Dodd examine the roles of both present and future prospects (with an appropriately skeptical view of the latter). They consider the implications of the quantitative analyses of financial statements and qualitative appreciations of less easily quantifiable factors, like management. In the key area of quantitative analysis, they look comprehensively at all financial statements, including most notably a firm’s balance sheet.

In this they were at odds with their contemporaries. In describing those practices, Graham and Dodd noted,

 

We find little beyond the rather indefinite concept that “a good stock is a good investment.” “Good” stocks are those of either (1) leading companies with satisfactory records, . . . or (2) any well-financed enterprise believed to have especially attractive prospects of increased future earnings. . . . Balance-sheet values are considered to be entirely out of the picture. Average [historical] earnings have little significance when there is a marked trend. The so-called “price-earnings ratio” is applied variously, sometimes to the past, sometimes to the present, and sometimes to the near future. (p. 29)

 

This description might have been written today. So-called price-earnings ratios continue to dominate valuation discussions. They are applied even more “variously” than in the past; now they include the ratio of a stock’s price to its earnings before interest and taxes (EBIT) and/or more perniciously the ratio of a stock’s price to its earnings before interest, taxes, depreciation, and amortization (EBITDA). Balance sheets are once again almost “entirely out of the picture.” Today, as in 1934, a “thorough” analysis of intrinsic value encompassing all the relevant information remains the exception rather than the rule.

With respect to the balance sheet, Graham and Dodd describe four fundamental areas of usefulness. First, the balance sheet identifies the quantity and nature of resources tied up in a business. For an economically viable enterprise, these resources are the basis of its returns. In a competitive environment, a firm without resources cannot generally expect to earn any significant profits. If an enterprise is not economically viable, then the balance sheet can be used to identify the resources that can be recovered in liquidation and how much cash the resources might return.

Second, the resources on a balance sheet provide a basis for analyzing the nature and stability of sources of income. As Graham and Dodd note,

 

There are indeed certain presumptions in favor of purchases far below asset value and against those made at a high premium above it. . . . A business that sells at a premium does so because it earns a large return upon its capital; this large return attracts competition, and, generally speaking, it is not likely to continue indefinitely. Conversely, in the case of a business selling at a large discount because of abnormally low earnings. The absence of new competition, the withdrawal of old competition from the field and other natural economic forces may tend eventually to improve the situation and restore a normal rate of profit on the investment. (pp. 557–558)

 

Here, they recognize that earnings on assets that are well in excess of a company’s cost of capital will be sustainable only under special circumstances. Thus, earnings estimates will be more realistic and accurate if they are supported by appropriate asset values. Earnings without such support are likely to be of short duration and, thus, of less value than earnings protected by the necessary returns on assets in place.

Third, the liabilities side of the balance sheet, which identifies sources of funding, describes the financial condition of the firm. A high level of short-term debt (or long-term debt that expires in the near future) indicates a possibility of debilitating financial distress. Under these circumstances, even a slight impairment in profits may lead to significant permanent loss in the value of a business.

Fourth, the evolution of the balance sheet over time provides a check on the quality of earnings. Today, this is covered, in principle, by the statement of cash flows, which should reconcile revenue and cost flows with changes in overall financial position. However, it remains true, as Graham and Dodd noted,

 

that the form of the balance sheet is better standardized than the income statement [or the statement of cash flows] and it does not offer such frequent grounds for criticism. (p. 93)

 

A balance sheet is a snapshot of a company’s assets and liabilities at a particular time. It can be checked for accuracy and value at that moment. This places significant constraints on the degree to which the assets and liabilities can be manipulated. In contrast, flow variables such as revenue and earnings measure changes over time that by their nature are evanescent. If they are to be monitored, they must be monitored over an extended period. In 1934, and today, this fundamental difference accounts for the superior reliability (in theory) of balance sheet figures. Indeed, as we will discuss later, while the stock market was celebrating WorldCom’s earnings growth in the late 1990s, signs of financial stress were already showing up in the balance sheet, stresses that would eventually lead to one of the largest bankruptcies in history as measured by the face value of the company’s debts.

 

Thorough Analysis

The special importance that Graham and Dodd placed on balance sheet valuations remains one of their most important contributions to the idea of what constitutes a “thorough” analysis of intrinsic value. It is also, [540] Introduction to Part VI unfortunately, one of their most frequently overlooked contributions outside the relatively small community of value investors.

The reason that the balance sheet is often ignored goes back to the times that produced Security Analysis. Back then, the economy and businesses were operating under severely depressed conditions. As a result, Graham and Dodd went to balance sheets to determine liquidation values or, as a proxy for these, current assets minus all liabilities. The logic behind this predisposition was compelling and conservative. If a company could be bought at a price well below its liquidation value, then it seemed unambiguously to be a bargain. Earnings could pick up because of either an improvement in a firm’s industry environment (competition eases or demand recovers) or better management. If the earnings improvement produced a market value above liquidation value, all well and good. On the other hand, if such positive earnings developments failed to materialize and if this happened before the liquidation value of the firm was significantly damaged, then the company could be liquidated and the proceeds distributed to its shareholders. In either case, the shareholders who bought below liquidation value would earn a “satisfactory return” on their investment.

The only risk, of which Graham and Dodd were well aware, was that management would continue to operate the firm unprofitably and, in the process, dissipate the value of the assets. Thus, they advocated their own version of shareholder activism as a necessary complement to this kind of investing. As they wrote,

 

The choice of a common stock is a single act; its ownership is a continuing process. Certainly there is just as much reason to exercise care and judgment in being a stockholder as in becoming a stockholder. It is a notorious fact, however, that the typical American stockholder is the most docile and apathetic animal in captivity. (p. 575)

 

Taken as a whole, this approach was unimpeachable and, in its time, successful in practice.

Since then the practice of buying below liquidation value has been undermined by two factors. First, the rapid rise in tax rates post-1940 has meant that strategies like this one, which have often involved realizing short-term gains over relatively short periods, have incurred high tax costs. Second, and more importantly, opportunities to buy stocks at prices below liquidation value, which were abundant in the 1930s, have effectively disappeared in the long-term prosperity that has followed. Relatively few industries in recent times have become economically nonviable and hence candidates for liquidation. This reality has been embodied in the general level of stock prices, with the result that Graham and Dodd’s much beloved “net nets”—that is, companies selling below the value of their current assets less all liabilities—are rare. And, when net nets are available, their second requirement—namely, that management not be dissipating those assets at a rapid rate—is seldom met.

However, the broader lessons that led Graham and Dodd to focus on the balance sheets of firms continue to apply, with extensions that are much within the spirit of their original approach. First, it is now recognized that for economically viable firms, assets wear out or become obsolete and have to be replaced. Thus, replacement value—the lowest possible cost of reproducing a firm’s net assets by the competitors who are best positioned to do it—continues to serve the role that Graham and Dodd recognized. If projected profit levels for a firm imply a return on assets well above the cost of capital, then competitors will be drawn in. That, in turn, will drive down profits and with them the value of the firm. Thus, earnings power unsupported by asset values—measured as reproduction values—will, absent special circumstances, always be at risk from erosion due to competition. Both “safety of principal” and the promise of “a satisfactory return,” therefore, require that “thorough” investors support their earnings projections with a careful assessment of the replacement values of a firm’s assets. Investors who do this will have an advantage over those who do not, and they should outperform these less thorough investors in the long run.

What appears to have deterred Graham and Dodd from considering the replacement value of assets was the potential difficulty of calculating them. They chose to focus on the wealth of new financial information made available through the establishment of the Securities and Exchange Commission. With today’s computers, that information can be obtained and digested almost instantaneously. Moreover, industry reports and trade publications, many of them available online, provide a wealth of information on asset values that was inconceivable to Graham and Dodd.

For example, the cost estimates of adding to existing reserves of oil and gas are widely available, at least for U.S. companies. So are estimates of recoverable deposits. As a result, investors today can calculate the values of resource companies’ holdings with a precision that was unattainable in the authors’ time. Physical property and equipment can also be valued with a higher degree of accuracy. For real estate, assessors with access to extensive transactions data can quickly and cheaply estimate the cost of purchasing comparable properties.

For other plant and equipment, consulting engineers and industry experts can provide this information. Using these sources, the cost of adding aluminum fabricating capacity to existing plants could be estimated at about $1,000 per ton per year. Existing capacity was available to handle any foreseeable demand. The then current earnings of aluminum fabricators lead to market valuations which implied that their existing capacity was worth well in excess of $1,000 per ton per year. The result: a race to build new capacity to take advantage of the potential earnings to be had in the fabricating business. This overexpansion resulted in falling earnings and lower stock prices. Such companies proved to be unsatisfactory investments. You could have anticipated this development only through a thorough analysis of the balance sheet.

Another area of difficulty that Graham and Dodd recognized was the valuation of intangible assets—product portfolios, customer relationships, trained workers, brand recognition—many of which do not even appear on a firm’s balance sheet. But today available information sometimes allows these balance sheet items to be usefully estimated. Some of this information comes from financial statements. For example, the cost of replicating product portfolios, assuming these are not protected by patents, can be estimated using historical research and development data both from a company itself or other companies in its industry.

This analysis can be supplemented by expert information. Investment initiatives—whether new products, new store openings, or brand launches—are almost always based on detailed business plans. These plans identify the costs of such initiatives with reasonable accuracy and the benefits more fancifully. Investors can use these data to estimate the cost of producing intangible assets. Industry managers with substantial experience will be able to estimate such costs.

More importantly, many intangible assets trade just like real property. Cable franchises, clothing brands, new drug discoveries, store chains, and even music labels are bought by sophisticated buyers (usually larger companies) from sophisticated sellers (usually smaller companies). The prices paid in these private market transactions are presumably made with the alternative cost of internal development in mind. Thus, if a company like Liz Claiborne buys a brand that is similar to its own in-house brands for 50 cents per dollar of sales, then presumably this is reasonably close—but lower than—the cost of reproducing its own brands. These private market values are often used by sophisticated investors to price intangible assets.

Once a thorough analysis of asset and earnings power value is complete, there are three possible situations. The first is one in which the asset value of a company exceeds the value of its foreseeable earnings. That tells you the assets are not being used to full advantage by management. Here, the critical factor for value investors is the prospect of some catalyst that will alter either the behavior or identity of current management. Graham and Dodd were aware of this although they were not cognizant of the range of interventions available to activist investors today.

A second possibility is that earnings power may exceed the asset value of a company. To maintain those superior profits, there needs to be some economic factors to protect the firm from competition. Today, these factors are referred to as “moats,” franchises, barriers to entry, or competitive advantages. What they look like and how they can be assessed is an essential part of modern income statement analysis. However, even in this case where asset values are least relevant, they do provide useful information about the value a firm will retain if the factors erode in the future.

The third case is one in which the earnings power and asset value of a firm are approximately equal. This is the circumstance that should hold with reasonable management and no special protections from competition. If qualitative judgments support such conclusions, then the asset value provides a critical check on the validity of earnings projections. A thorough asset valuation then helps to provide a complete picture of what an investor is getting for a security and helps that investor settle with confidence on an appropriate margin of safety.

Beyond these specific uses of asset valuations in current practice, there is one final inescapable area in which asset values must be used. Firms often have some assets—most notably cash—that are superfluous to the operation of their basic businesses. Such assets do not usually contribute to operating earnings, but they may represent an important part of the intrinsic value of a purchased security. The value of these assets must be added to any earnings-based value estimate (after appropriate subtraction of their interest income so as not to double count). Performing a comprehensive asset valuation ensures that they are not forgotten.

 

WorldCom: A Case Study

The financial statements of WorldCom, the telecom giant whose bankruptcy filing in the summer of 2002 was at its time the largest ever, illustrate the usefulness of a balance sheet analysis for tracking the financial condition of companies. Indeed, anyone who had been studying the balance sheet in the few years ahead of the bankruptcy would have suspected the company would come to no good end. For instance, in the middle of 1999, WorldCom had an equity market value of $125 billion. This compared to a year-end 1999 book value of $51.2 billion, which had been created almost entirely by issuing shares for acquisitions, notably $12 billion for MFS Communications in 1996 and $30 billion for MCI in 1997. Retained earnings over the company’s 15-year history were negligible, so over 85% of the book value was goodwill and other intangibles. The ratio of market value to tangible net equity was in excess of 15. Such ratios will vary by industry, but in this case, 15 is ridiculously high.

How valuable were those intangibles? Not worth as much as the company said because they included neither significant patents nor developed process technologies. Even more important, WorldCom’s business was characterized by high rates of customer churn and vigorous price competition for its telecommunications and data transmission services. Nor did there appear to be large barriers to entry that might have supported a market value significantly in excess of reproduction value, or what it would cost to reproduce the network. WorldCom’s markets were characterized by many new entrants (including those companies acquired by WorldCom) and vigorous expansion by powerful existing competitors like AT&T. If anything, to the extent that economies of scale were relevant, WorldCom would have been operating at a significant competitive disadvantage to its larger competitor, AT&T.

However, what is more remarkable than the improbable market value placed on WorldCom’s assets is the detailed story told by the evolution of its balance sheet. From year-end 1999 to year-end 2000, net property, plant, and equipment increased by 27%, or about $8 billion. In contrast, revenues increased by only 8%. That raised the question, why was such an aggressive investment program underway at the company? In fact, the investment figures turned out to have been fraudulently inflated by booking operating expenses as investments. However, even if they had not been fraudulent, the aggressive acceleration in property, plant, and equipment growth (up from about $5 billion in 1999) in the face of decelerating revenue growth should have raised questions about the management’s judgment. The likelihood of a bad outcome from this insouciant attitude toward overexpansion should have been apparent.

Over the course of 2001, these consequences became clearly evident. During 2001, WorldCom’s short-term debt almost entirely disappeared as current debt liabilities fell from $7.2 billion to $172 million. In marked contrast, long-term debt rose by about $12.5 billion. In fact, it actually increased by about $14 billion since an examination of the balance sheet footnotes indicated that more than $1 billion of additional long-term debt had disappeared by the accounting expedient of deconsolidating the subsidiary responsible for that debt. The fact that, in the face of now declining revenues, WorldCom felt that it needed an additional $7 billion in debt financing—all of it long term—should have set off an alarm with any investor who bothered to look at the balance sheet.

What happened? In 2000, WorldCom’s management lost control of its finances, making at best a highly risky bet on future revenue growth and at worst a calculated effort to disguise deteriorating operating margins by capitalizing expenses. In 2001, WorldCom scrambled for long-term financing, by which the company hoped to give management many years to solve problems. There was really no choice since attempting to sell equity in the face of a falling stock price would have sent a disastrous signal to the market. The primary vehicle WorldCom used was an $11.9 billion debt sale to the public in May 2001, underwritten by financial institutions that justified the issue in terms of future earnings and cash flow.

If these institutions and their customers had followed Graham’s advice to look carefully at the WorldCom balance sheet, they would have known better. They might not have fully anticipated the fraud and subsequent bankruptcy of WorldCom, but they would have seen enough to avoid both its stock and bonds as investments unlikely to provide either protection of principal or promise of a satisfactory return. (535-547)