The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.
Graham uses this chapter to illustrate security analysis. A lot of data is given, which I will not reproduce in full. Rather than reproduce the bulk of the chapter here, I will try to show, at a high level, what Graham does.
He looks at four companies
First, he starts by looking at their P/E in the most recent year vs. their average P/E over a series of years in the past. He shows that two appear to be priced quite high given their earnings.
Next, Graham looks at the chief elements of performance:
All show satisfactory earnings on their book value, though two (the two mentioned above as being highly priced) are somewhat higher. All have satisfactory operating income to sales, which shows the profit figure per dollar of sales. This is a good indicator of comparative strength or weakness.
He looks at the maximum decline in EPS for the last 10 years as against the average of the three preceding years. The two high priced stocks had no decline, which = 100% stability. The other two had quite modest shrinkage of 8%, in a year where the DJIA declined 7%, so this is nothing to worry about.
The low multiplier companies had satisfactory growth rates, beating the DJIA. The two high priced companies had greater growth.
4. Financial Position
Three of the companies are manufacturing companies, and are in strong financial condition with 2:1 ratio of current assets to current liabilities (This is the Current Ratio). The non-manufacturing company had a lower current ratio, which not uncommon for the industry it is in. All of the companies have little long-term debt.
One of the companies has an uninterrupted history of dividends dating back to 1902. Two of them are also quite strong, while one is a newcomer. The current dividend on the low-priced stocks were twice that of the high-priced pair, corresponding to their P/E ratios.
6. Price History
All have advanced significantly during the past 34 years. Where the DJIA advanced by 11x in that period, these companies advanced by at least 17x, to a maximum of 528x. All suffered serious setbacks as of recently, in line with the rest of the market, but rebounded shortly thereafter.
A quantitative analysis ensues, looking at the companies in the context of their industries. This is an important step, but the detail given is too long for a blog post.
Graham determines that the high priced stocks are bad buys because such a large portion of their share prices are due to speculation. Additionally, it appears that their previous growth was achieved while the companies were smaller, and it will be difficult to maintain such growth into the future.
Graham says that the low priced companies are the best buys here. Their current low prices are a bargain for the value of the assets of the company. The return on invested capital has been satisfactory, as is the stability of their profits.