Sunday, August 10, 2008

Security Analysis: Chapters 42 and 43

Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.

This chapter focuses on using the balance sheet to help determine the worthiness of an enterprise. As a starting point, an adjusted book value will help give the investor an idea of the net assets he is purchasing. Therefore, the authors take the readers through example calculations of book value, being careful to gross up preferred stock to its effective value (not necessarily the same as what's on the books), and removing intangible values.

The significance of book value has changed over the years. Graham and Dodd submit that they used to be all-important for stock purchase, and therefore companies would take pains to show as large an equity base as possible. Now that current earnings are the dominant determinant for a stock price, companies will often write down their fixed assets in order to maximize their future earnings.

The authors also introduce the concepts of current-asset value and cash-asset value, where all liabilities are subtracted from the company's quick assets and cash respectively. The authors believe current-asset value offers an approximation to the liquidation value of a business, one that is more accurate than book value.

They find a number of stocks trading at discounts to their current-asset values, noting that this suggests these companies are worth more dead than alive! Indeed earnings and their trends have been poor for this group, which is why they sell at such a depressed price. However, it is not uncommon to find changes (whether in industry, company operations, a merger, or liquidation) resulting in gains for stockholders who have purchased at this depressed level.

The investor must be careful that the company is not in danger of continuing to lose large amounts of money, however. If he should find companies trading at discounts to their current-asset values, he should ensure that at least in the near past this company has had a decent earning power.

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