In the last video in this miniseries of Security Analysis, I gave a brief introduction on the subject of analyzing securities in the markets. Among other things, the difference between an investment and a speculation was explained, and if you haven't watched that video yet, I strongly suggest you do before watching this. For this video, we are going to talk income statements and balance sheets. I'll explain why they are important to consider, and what to look for, not as an accountant, but as an investor. If you're completely unfamiliar with these two financial statements, I suggest that you watch this video before continuing here. Now let's dive into the second part of Benjamin Gray Ham's masterpiece. Takeaway number 1: Analyzing the income statement Let's start out with the income accounts. This reveals the historical earnings of a company, which, in turn, is a good indicator of how much investors have received during the same period.
The study of this statement goes under three separate headings: The accounting aspect – what are the true earnings of the past? The business aspect – what does this indicate for the future? And the investment aspect – based on this indication, what is a reasonable valuation of the security? In the previous video, I stated that: "Data in company reports may not always present the situation in a useful manner to the investor." Now, allow me to present an absurd hypothetical example to show you why. Imagine that you have the possibility to invest in one of three different YouTubers.
Youtuber A, B and C. They produce videos in the same niche. All of them have the same revenue, say $500 per year, which they generate from ads, and they all have 100 shares outstanding. They all bought computers for their companies during their first year of business. YouTuber A paid $2,500 for his, while B and C paid $1,250 for theirs. A and B decides to depreciate, or in other words, write down the value of their computers, over five years. C, on the other hand, decides to write off the whole stated value in the balance sheet in just one year. Two years later you decide that you wanna invest in one of these businesses. At a first glance, when you observe the earnings of year two, it may seem like company A earned nothing at all, B earned $2.5 per share, and C earned $5 per share. When the novice investor sees this, he is not willing to pay much for a share in company A, perhaps just speculative $2, hoping that the profit margins will increase soon. For B and C on the other hand, he might be willing to pay, for example, ten times the annual earnings, or in other words, $25 and $50 per share respectively.
Someone with the interest of buying the whole businesses would realize how absurd this is. Really?? Paying 25 times more for a similar company that generates the same amount of cash? Naaaah … Besides, company A has assets at a total value of $2,500, while C has (realistically not according to the books) assets at a value of $1,750. So there's even an argument to pay more for company A than for C. Even if this example is a bit extreme, I hope that you get the point Earnings play a major role in deciding the valuation of companies, and yet, sometimes they reveal so little about how the business is truly doing.
You need to be able to adjust the earnings yourself, so that they give a fairer representation of the past, and for this, we need to learn about some of the common ways that companies distort their performances. And unfortunately, they are typically disguised better than in this hypothetical example that I just showed. Takeaway number 2: Six common ways to misrepresent earnings In deciding what the true earnings of the past are, we want to understand what Benjamin Graham calls the company's "earnings power". This can be considered as the ordinary operating earnings of the business. But the analyst must remember that even after adjustments he will only get a more nearly correct version of the past. Correcting the income statement is done through a "via negativa" approach, as Nassim. Taleb would call it. We remove what's wrong, and then we get something that is correct. Well nearly correct, at least. Here are six common ways to confuse investors. Accelerating depreciation.
Here's how depreciation works in theory: if a capital asset has a limited life, provision must be made to write off the cost of the asset by charges against earnings, distributed over the period of its life. But in practice, companies don't always follow this. Sometimes they decide to write these assets off faster than the lifetime of the asset suggests, such as YouTubeer C did in our previous takeaway. This will make it so that the earnings in the following years will appear greater than they really are. Beware. Decelerating depreciation At other times, depreciation happens too slowly.
If YouTuber A, for example, would have used a straight-line depreciation of ten years for his computer, instead of five, It would have appeared as if he had earned $250 more in every year. But obviously, the earnings power of his company wouldn't have been $250 stronger, and neither would it have been worth more to an investor just because he used another method of accounting. Allocating expenses to the balance sheet instead of the income statement. Companies sometimes "capitalize" normal operating costs, which means that they reduce their expenses in the income statement by moving them to the balance sheet, building up long term assets. Thus, income statement earnings are increased. The YouTuber is in a very interesting situation here. If he creates content that can be consumed over many years, should expenses associated with his video-making be considered operating expenses or capital expenses? Pretending that EVERYTHING is extraordinary. Extraordinary expenses should typically be removed, and thus increasing the numbers when calculating the true earnings power of a company. But, as you probably have guessed already, some companies are sneaky here.
Let's say that the YouTuber bought some merch that didn't do very well. He'd have to write down the value of the merch on his balance sheet, which will affect earnings negatively. But if he decides to call this expense "extraordinary", the normal investor will typically overlook this in his valuation of the business. Recording revenues prematurely. Even though all services in a contract haven't been fulfilled yet, all earnings may be recorded in the current period. Let's say that the YouTuber has a partnership with another channel, where he's supposed to create a new series.
He's paid when the full series is done. At the end of the first year, he might have completed, say, half the series, but decides to record the full contractual revenue in the current year anyways. Moving current expenses to the next year … or the year after that. The height of hypocrisy is reached if a company records its earnings prematurely, but then takes the exact opposite stance when it comes to expenses. Let's say a YouTuber wants to set up a website for his channel, and hires a programmer to do so. Maybe the website is up and running, but there's still an ongoing contract for updates and maintenance after the first year. The investor will want to see the expenses accumulated so far in the income statement, but the books may fail to show this, as "future services still remain". If you are uncertain, always compared to competitors within the same industry, something which we'll discuss in the next video. And also, when doing these adjustments, always remember that: "Security analysis is a severely practical activity, and it must not linger over matters that are not likely to affect the ultimate judgement." Takeaway number 3: What does this indicate for the future? All right.
So we've kind of answered the first question – what are the true earnings of the past? Now for the second one – what does this indicate for the future? Let's consider two different types of hypothetical earning records. Which one do you think provides a better guide for the future? Obviously, it is A. We've said in the last video, that the future is no respecter of the past, and this still holds true. But … Past earnings give a rough indication, and you can trust in this indication more if: – The earnings record is longer – An average is used – It includes whole market cycles – The business is stable Follow-up question: How do you think the earnings of these two companies will develop in the next five years? It is truly tempting to just project the earnings trend of the past into the future.
According to Benjamin Graham, one must be very cautious when doing this though. Investment value can be related only to demonstrated performance. "Competition, regulation, the law of diminishing returns, etc are powerful foes to unlimited expansion, and in smaller degree, opposite elements may operate to check a continued decline." Or, in other words, neither abnormally good nor abnormally bad conditions for a business lasts forever. In the third and the fourth video we will answer the third question – what is a reasonable valuation of the security? Takeaway number 4: Analyzing the balance sheet We've now arrived at the other important financial statement that existed during Benjamin Graham's time as an investor – the balance sheet. Instead of using only earnings from the income statement as a basis for your investment. which, as we've seen, is both fluctuating and the subject of misleading representation, why not use a 2-fold test? Going back to takeaway number one, surely you would like to acquire the YouTuber with a more valuable asset, everything else equal.
I mean … in case he decides to stop putting up these YouTube videos and leaves the company, you can at the very least sell his computer on eBay and get some of your money back, limiting the downside. The usual purpose of analysis of the balance sheet is to weed out weak companies. For example, you can identify if the company has: Liquidity issues, by looking at the current ratio and insisting that it's greater than 2. Problems paying interest charges, by looking at the interest coverage ratio (more on this in video number 4, though). Too much or perhaps too little debt, more on this in the next take way. Or problems with sales, by looking at the inventory levels and how they have changed over time. Don't overlook the balance sheet! Assets and liabilities surely aren't as sexy as revenues and profits, but they are just as important for the intelligent investor … and more dependable! Takeaway number 5: The importance of capitalization structure A central part of the balance sheet, is that of how the company has been financed – often part equity and part liabilities, sometimes issued as bonds. This is referred to as the "capitalization structure" of a company.
Let's return to the three YouTubers. Neglect their computers, but remember that they earned $500 per year. Company A is capitalized solely by equity, company B as a mixture of common stock and $2,000 in bonds, at a 5% interest rate, while company C has common stock and $6,000 in bonds, also at 5%. After deducting the interest expenses from the revenues of each of these companies, they earn the following amounts per year. Let's again assume that their common stock is valued at a p/e of 10, and therefore, the total value of the common stock of the companies should be as follows. Adding the value of the bonds to reach a total valuation for each company, we notice something interesting. The total value of company B is $1,000, or 20% higher than that of A, and the enterprise value of C is even $3,000 higher, or 60%! How can it be that companies with the same earnings power, can be valued so differently, based solely on capitalization? Can it? To answer this question, we must understand whether it's reasonable to value the common stock at a p/e of 10 and the bonds at the so called "par value", in each of these cases.
Let's compare company B to company A. There's no reason to believe that the bonds of company B would be priced lower than par. The company is earning five times its interest expenses, which provides a margin of safety (more on this in the fourth video). Sure, the common stockholders of company B are more vulnerable to shrinkage in revenues than company A, but this is offset by the leverage that they have compared to shareholders of company A in the case of an increase. Paradoxical as this may seem, we must thus accept that Company B is worth $6,000, or 20% more than A merely because of its capitalization structured. Benjamin Graham states the following as a rule of thumb: "The optimum capitalization structure for an enterprise includes senior securities to the extent that they may safely be issued and bought for investment." With company C, on the other hand, we are not convinced regarding the "safety" and "bought for investment" part.
A bond, earning only 1.66 times its interest expenses, is typically not seen as safe. The threshold for industrial companies, for instance, is 3 according to Graham. Furthermore, the earnings of the common stock of company C are even more leveraged. And thus, up- and downswings in the revenues have an even greater effect (percentage-wise) on the profits for shareholders. In this case though, the leverage may frighten some conservative investors, and this will decrease the demand for the stock, and in that, also the price and the p/e. So it's safe to say that the value of company C wouldn't be a total of $8,000, and probably, it could be valued even lower than company A. We conclude by calling the capitalization of company A "overconservative". That of B, "appropriate" or "suitable", and that of C "speculative". It's summary time! The first priority of analyzing an income statement is to understand what the true earnings of the past have been.
There are many ways that earnings can be misrepresented. By being aware of these tricks, the intelligent investor can adjust the historical figures to a more correct version. Averages and long records make assumptions about future earnings more reliable. Weed out weak companies by the careful study of balance sheets. Some debt can actually be beneficial to the investor in common stocks, as his invested amount becomes more productive when a reasonable part of the capital is borrowed. In the next video, it's finally time to talk common stocks, and after that, in the last video, of this miniseries we'll discuss senior securities. Cheers!.