Intelligent Investor Ch.11 - Security Analysis

Security Analysis for the Lay Investor: General Approach

Is there any difference between Financial Analysis and Security Analysis? As we can read in the book security analysis is more limited than financial analysis in the way that financial analysis covers a big amount of general economic analysis, such as e.g. macroeconomics etc.!

The work of a security analyst covers:

• Deals with the past, present, and future of any given security
• Describes the business, its operating results, and financial position
• Determines the strong and weak points, the possibilities and risks
• Estimates the future earning power under various assumptions
• Elaborate comparisons of several companies or within the same company at different times
• Formulates an opinion as to the safety of the bond, preferred or common-stock

The security analyst may look at the calculations in the financial statements of a company differently than the reported numbers, and search for specific items in these reports that may create another view of the company!

There are certain standards-of-safety that need to be passed or met for bonds and preferreds before justifying an investment in these. For common-stocks, there are as well certain "standards" that need to be met. It is certainly not only mathematical or scientific calculations of past earnings and future projections that give us a buy or sell decision for investing. As soon as advanced mathematics comes into the game of investing, higher than 3rd-grade math (elementary algebra), to calculate exactly stock prices in future, you should back-off!

Security analysis for the lay investor is thought of as beginning with the understanding of a company's annual reports, i.e. painting the picture of a company's story!

Bond Analysis

In bond and investment-grade preferred stock analysis, your concern is with the safety or quality of those issues!

The main criteria for bonds are the number of times that total interest charges have been covered by available earnings for some years in the past! The basic test applies to a minimum coverage of the average result of the past seven years! There is as well an alternative test measured by the "Poorest Year" - you can choose either or!    

To make it practical, calculate the 7-year average earnings from a company's annual reports (Form 10-K) and divide it by the latest report Interest Expenses. Graham states different minimum coverage ratios by enterprise type, starting at the lowest at 3 times! 

On top of the earning-coverage test following points have to be addressed:

• Size of Enterprise: Business volume or population for a municipality
• Stock-Equity Ratio: Ratio between the market price for common-stock to the total amount of debt. This is a "rough" measure
• Property Value: The asset value (on the balance sheet) is again a separate test and shows some good understanding security of the bonds

All of these tests are done with numbers in the past or present, but not for future safety. It has been shown that very few enterprises in the past have shown problems as long as they stayed over the earnings-coverage test in combination with the additional checkpoints above!

Common-Stock Analysis

The ideal situation is to get the value of the company and compare it to the current market price to judge if it is an attractive purchase. Normally, to "calculate" a value, you estimate average earnings over a period of years in the future and then multiplying that estimate by an appropriate "capitalization factor"

The defacto standard way of doing it is to analyze past company data and then try to estimate future earnings, based on volume, prices, and margins development, etc.  It is very hard, and very unlikely, to do this for a company or by that for a full industry or sector!

Factors Affecting the Capitalization Rate 

The multiple that works in conjunction with the estimated future earnings, i.e. Capitalization Rate needs to be determined and as a base assumption we need to consider the following areas:

1. General Long-Term Prospects
2. Management
3. Financial Strength and Capital Structure
4. Dividend Record
5. Current Dividend Rate a.k.a. Dividend Payout Ratio

1. General Long-Term Prospects: Nobody knows what will happen in the future, but many analysts have a strong view of companies or industries in the future. These views are reflected in the price-earning ratio, I cite from the book:

"...at the end of 1963 the chemical companies the Dow Jones Industrial Average (DJIA) were selling at considerably higher multipliers (red. PE's) than the oil companies, indicating stringer confidence..." 

Ironically the chemical companies, despite their high multiplier, made practically no gain in earnings and the oil companies did much better than the chemicals!

These views, also Wall Street's consensus of the future for any given sector is usually either too optimistic or too pessimistic. Worse, the consensus is at its most bright just when the stocks are most overpriced - and darkest just when they are cheapest

2. Management: Another difficult topic to foresee is how good management is and how well that will translate in better earnings etc. But it is fair to say that outstanding successful companies have unusually good management! This will have proved in past performance and it will show up in future estimates and in long-term prospects - the problem is that good management with a good company performance is normally high in price!

3. Financial Strength and Capital Structure: Which company is better - company "Cash is King" or company "Big Bank Loans"? Easy question, right! A reasonable amount of debt or leverage is more than ok, but high leverage companies can be dangerous and speculative!

4. Dividend Record: This is especially for the Defensive Investor, and to pass the test, the company should have a record of continuous dividend payments for the last 20 years or more, yes 20 years!

5. Current Dividend Rate a.k.a. Dividend Payout Ratio: This is how the company intends to pay out dividends or called the standard dividend policy, e.g. 50% of average earnings will be paid out as dividends. Most growth companies will keep 100% of the earnings to finance further growth as they have a higher return on their investments which in the end will benefit the shareholder more than dividends!

Capitalization Rates for Growth Stocks

Due to experience, Graham has come up with a simple formula to value a growth stock:

 The growth rate taken here should be the expected growth rate over the next seven to ten years. The following table shows some common multiples and its growth rate:

Keep in mind that these are approximate values, not certain ones!

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Rule of 72: This is a simple way to determine how long an investment will take to double given a fixed annual rate! Look at the table above, on the column with the expected growth rate of 7.2%! Divided 72 with 7.2% you get 10 years to double! Another example, how long does it take to double if the growth rate is 26%?? - Correct, 72 divided by 26 is? - Or if you want to double your investment in 5 years, what kind of growth do you need to have? Correct, 72 divided by 5 is?
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A Two-Part Appraisal Process

This is a very practical approach how to attack the different variables, i.e earnings and growth rate, in valuing a company or its common stocks.

Step 1 is to find the "past-performance value", which is based only on the past performance and how that is worth today, and its relative past performance will continue as the last years - the assumption is that the growth rate for the last seven years will be the same the coming seven years.

Step 2 is then to analyze the past performance and how the future will change in relation to past performance!

But it is stressed again in the book that this is just a starting point!