SECURITY ANALYSIS - FINANCIAL STATEMENTS (BY BENJAMIN GRAHAM)

Summary

This video script delves into the intricacies of security analysis, focusing on the importance of income statements and balance sheets for investors. It differentiates between true earnings and misleading financial representations, outlining six common methods companies use to distort earnings. The script also emphasizes the significance of analyzing a company's capitalization structure and how it can affect the valuation of common stocks. The video aims to educate investors on identifying weak companies and understanding the impact of leverage on investment value.

Takeaways

• 📈 Takeaway 1: The importance of analyzing income statements and balance sheets for investors, beyond just accounting, includes understanding a company's historical earnings and future prospects.
• 🔍 Takeaway 2: Earnings can be manipulated through various accounting practices, such as different depreciation methods, which can distort a company's true financial performance.
• 💰 Takeaway 3: Investors should adjust earnings to reflect a fair representation of a company's past performance and be aware of common ways companies misrepresent earnings.
• 🚫 Takeaway 4: Six common ways companies misrepresent earnings include accelerating or decelerating depreciation, capitalizing operating expenses, treating ordinary expenses as extraordinary, recording revenues prematurely, and deferring expenses.
• 🔮 Takeaway 5: Past earnings provide an indication of future performance, but investors must be cautious in extrapolating trends and consider the stability and cyclicality of the business.
• 💼 Takeaway 6: Analyzing the balance sheet is crucial for identifying weak companies and understanding a company's financial health, including liquidity, debt levels, and asset management.
• 🏦 Takeaway 7: Capitalization structure, which includes both equity and liabilities, plays a significant role in a company's valuation and affects the risk and return profile for investors.
• 📉 Takeaway 8: Companies with similar earnings can have different valuations based on their capital structure, with more debt potentially increasing value but also risk.
• 📊 Takeaway 9: The balance sheet provides a more dependable assessment of a company's financial position compared to the fluctuating income statement.
• 📘 Takeaway 10: Investors should use a combination of income statement analysis and balance sheet review to make informed investment decisions, considering both the company's past performance and financial stability.

Q & A

What is the primary focus of the video script provided?

The video script focuses on the analysis of securities, particularly on income statements and balance sheets, and how to understand and interpret them from an investor's perspective rather than an accountant's.

Why are income statements and balance sheets important for investors?

Income statements and balance sheets are important for investors because they provide insights into a company's historical earnings, financial health, and future prospects, which are crucial for making informed investment decisions.

What is the difference between an investment and a speculation as explained in the video?

The video suggests that an investment is based on thorough analysis and understanding of a company's financials, while a speculation is more about taking risks without a solid basis in the company's performance or financial health.

What are the three separate headings under which the income statement is studied according to the script?

The three separate headings are the accounting aspect, which focuses on the true earnings of the past; the business aspect, indicating what this means for the future; and the investment aspect, which is about determining a reasonable valuation of the security based on these indications.

Why might a novice investor be misled by the earnings of YouTuber A, B, and C in the hypothetical example provided?

A novice investor might be misled because they might only look at the surface level earnings without considering the accounting methods used for depreciation, which can significantly distort the true picture of a company's earnings and thus its valuation.

What is the concept of 'earnings power' as mentioned in the script?

'Earnings power' refers to the ordinary operating earnings of a business, which is an important measure for understanding the company's true profitability over time, after adjustments for non-recurring or extraordinary items.

What are the six common ways companies might misrepresent earnings as outlined in the script?

The six common ways are: accelerating depreciation, decelerating depreciation, allocating expenses to the balance sheet instead of the income statement, pretending that everything is extraordinary, recording revenues prematurely, and moving current expenses to the next year or beyond.

Why is it important to adjust the earnings figures when analyzing a company's financial statements?

Adjusting the earnings figures is important to get a more accurate and fair representation of the company's past performance, which helps in making more informed investment decisions by eliminating distortions and presenting a clearer picture of the company's financial health.

How can the length and stability of a company's earnings record impact the reliability of future earnings projections?

A longer and more stable earnings record, including whole market cycles, can make assumptions about future earnings more reliable because it provides a broader context and indicates a trend that is less likely to be affected by short-term fluctuations.

What is the purpose of analyzing a company's balance sheet according to the script?

The purpose of analyzing a company's balance sheet is to identify the company's financial strength and stability, weed out weak companies, and understand the company's capital structure, which includes how it is financed and the value of its assets and liabilities.

Why is the capitalization structure of a company important for investors?

The capitalization structure is important because it shows how a company is financed, the mix of equity and debt it uses, and can affect the value of the company and the risk associated with investing in it. Different capitalization structures can lead to different valuations even for companies with the same earnings power.

Outlines

00:00

💼 Understanding Financial Statements for Investors

This paragraph introduces the importance of income statements and balance sheets in security analysis from an investor's perspective, rather than an accountant's. It emphasizes the need to look beyond the numbers to understand the true earnings and financial health of a company. The video script discusses the three aspects of analyzing an income statement: accounting, business, and investment. It uses a hypothetical example of three YouTubers with different depreciation methods to illustrate how earnings can be misrepresented, affecting investment decisions.

05:06

📊 Six Common Ways to Misrepresent Earnings

The paragraph delves into six common methods that companies might use to distort their earnings, which can mislead investors. These include accelerating or decelerating depreciation, allocating expenses to the balance sheet, considering ordinary expenses as extraordinary, recording revenues prematurely, and moving current expenses to future years. The paragraph stresses the importance of understanding these manipulations to accurately assess a company's earnings power and make informed investment decisions.

10:10

🔮 Earnings Records and Future Indications

This section explores how past earnings records can serve as an indicator for future performance, with the caveat that past performance does not guarantee future results. It discusses the factors that can make past earnings a more reliable guide for the future, such as a longer earnings record, the use of averages, inclusion of whole market cycles, and business stability. The paragraph also cautions against simply projecting past earnings trends into the future without considering the limitations and potential changes in business conditions.

15:11

🏦 Analyzing the Balance Sheet and Capitalization Structure

The final paragraph focuses on the analysis of the balance sheet and the concept of capitalization structure. It explains how the balance sheet can be used to identify weak companies by examining liquidity, interest coverage, debt levels, and inventory changes. The paragraph also discusses the impact of different capital structures on company valuation, using the example of three YouTubers with varying debt levels. It concludes by emphasizing the importance of a suitable capitalization structure for an enterprise and the potential risks associated with overly conservative or speculative structures.

Keywords

💡Investment vs. Speculation

Investment and speculation are two distinct approaches to allocating resources in financial markets. Investment is characterized by a strategy based on thorough analysis and a focus on long-term value, whereas speculation is more about taking risks on short-term market movements. In the video, the distinction is essential for understanding the analytical approach to security analysis, where the emphasis is on making informed decisions rather than taking impulsive risks.

💡Income Statement

An income statement is a financial report that provides a summary of a company's revenues, expenses, and profits over a specific period. It is crucial for investors as it reveals the historical earnings of a company, which serves as an indicator of the returns investors have received. In the video, the income statement is discussed under three headings: accounting, business, and investment aspects, emphasizing the need to analyze earnings beyond mere numbers.

💡Balance Sheet

A balance sheet is a financial statement that presents a company's assets, liabilities, and shareholders' equity at a specific point in time. It is important for investors as it offers insights into the financial health and stability of a company. The video script highlights the balance sheet's role in identifying weak companies and understanding the company's capital structure.

💡Depreciation

Depreciation is the systematic allocation of the cost of a capital asset over its useful life. It is a non-cash charge that reduces the carrying value of an asset on a company's balance sheet. The video script uses depreciation as an example to illustrate how companies can manipulate earnings by accelerating or decelerating the depreciation process, affecting the perceived performance of the business.

💡Earnings Power

Earnings power refers to the normal operating earnings of a business, which is an important concept in security analysis. It represents the company's ability to generate profits from its core operations. The video emphasizes the need to understand a company's earnings power by adjusting the income statement to reflect a more accurate picture of the company's past performance.

💡Capitalization

Capitalization in the context of finance refers to the structure of a company's debt and equity financing. It is a critical aspect of a company's balance sheet and can significantly impact the valuation of the company. The video script discusses how different capitalization structures can lead to different valuations of companies with the same earnings power.

💡Extraordinary Expenses

Extraordinary expenses are non-recurring costs that are unusual in nature and infrequent in occurrence. They are typically excluded from the calculation of a company's earnings power to provide a clearer view of the company's ongoing profitability. The video script warns against companies that might misrepresent regular expenses as extraordinary to make their earnings appear better than they are.

💡Revenue Recognition

Revenue recognition is the process of recording revenue in the accounting records of a business when it has been earned according to accounting standards. The video script points out that some companies might record revenues prematurely, which can distort the true earnings of the company and mislead investors.

💡Capitalization Structure

Capitalization structure refers to the specific combination of debt and equity that a company uses to finance its operations. It is a central part of the balance sheet and can affect the company's valuation and risk profile. The video script uses the concept of capitalization structure to explain how the same company can have different valuations based on how it is financed.

💡Interest Coverage Ratio

The interest coverage ratio is a financial metric that measures a company's ability to pay interest on its outstanding debt with its earnings before interest and taxes (EBIT). It is an important indicator of a company's financial health, especially its capacity to meet interest payments. Although not explicitly defined in the script, the concept is alluded to when discussing the analysis of the balance sheet for identifying companies with problems paying interest charges.

💡Leverage

Leverage in finance refers to the use of borrowed money to increase the potential return of an investment. It can amplify both gains and losses. The video script discusses how leverage can affect the valuation of a company, making it either more attractive or more risky depending on the level of debt relative to equity.

Highlights

Introduction to the importance of analyzing securities and the distinction between investment and speculation.

The significance of income statements and balance sheets for investors.

Three separate headings for analyzing the income statement: accounting, business, and investment aspects.

The potential misrepresentation of company data in financial reports.

A hypothetical example illustrating the impact of different depreciation methods on company valuation.

The importance of adjusting earnings to reflect a fairer representation of a company's past performance.

Six common ways companies misrepresent earnings, including accelerating and decelerating depreciation.

The role of extraordinary expenses in adjusting the income statement.

The practice of capitalizing normal operating costs to manipulate earnings.

The caution required when projecting past earnings trends into the future.

The use of balance sheets as a tool to identify weak companies.

The importance of capitalization structure in company valuation.

How different capital structures can affect the valuation of companies with the same earnings power.

The concept of 'earnings power' and its role in determining a company's true earnings.

The practicality of security analysis and its focus on factors likely to affect the ultimate judgment.

The role of market cycles in evaluating the reliability of past earnings for future predictions.

The paradox of leverage in company valuation and its impact on both risk and reward for investors.

Benjamin Graham's rule of thumb for the optimum capitalization structure of an enterprise.

The summary of key takeaways from the analysis of income statements and balance sheets.

Transcripts

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!