Intelligent Investor Ch.13 - Four Listed Companies

A Comparison of Four Listed Companies

In this chapter, Graham compares four companies - so the question is what we can learn from the chapter! 

The biggest conclusion as cited below is:

"The most striking fact about the four companies is that the current price/earnings ratios vary much more widely than their operating performance or financial condition"

So on which basis did he do the comparison - the following parts were analyzed:

1. Profitability
2. Stability
3. Growth
4. Financial Position
5. Dividends
6. Price History

1. Profitability

- The first measurement mentioned was the earnings of the companies in relation to their book value. All companies showed >10% return on invested capital or as it is written in the book as net per share/book value. "A high rate on invested capital goes along with a high annual growth rate in earnings per share". All companies showed as well better earnings on book value compared to 8 years before, so growth is important here! 

- To measure comparative strength or weakness, the profit figure per dollar of sales was looked at or as we as well can say the ratio of Operating Income to Sales - or as we would say today the Operating Margin! The result here was as well satisfactory for the current year but as well the change between now and even 8 years before!

2. Stability

- This measure is done to decide the stability of mainly the earnings! As the book says "This we measure by the maximum decline in per-share earnings in any one of the past ten years, as against the average of the three preceding years". Here again, I want to stress that the average is taken instead of one good or bad year! It is as well important how much the shrinkage of earnings is in any bad year and what it depends on - to understand if this is temporary or if the company has other problems!

3. Growth

- The earnings growth is mentioned first of all but in comparison to the multiplier, i.e. price/earning ratio! Normally high growth companies have high P/Es and vice versa. One example was a low-multiplier company at a P/E of 10 who grew earnings +81% the last 7 years or +400% the last 10 years of course based on a 3-year average period!

 4. Financial Position

- This test is done to determine if the companies are based on sound financial condition. The first measure is the Current Ratio, i.e. that the minimum a company has is $2 in Current Assets to $1 in Current Liabilities.

- Another test is the long-term debt, and here Graham likes that the ratio between Working Capital to Debt is at least one, favorably higher! 

- If any share dilution is to be expected due to e.g. convertibles which can be turned into shares that will decrease per-share earnings should as well be calculated and adjusted for!

 5. Dividends

- A long time of unterinterrupted dividends is here the name of the game. One of the companies had over 60 years of continuance payments of their dividends! In the analysis, there was a remark that "the current dividend yield is twice as high on the cheap companies according to their P/E ratio compare to the expensive companies".

 6. Price History

- One term to look at here is how big the difference (red. spread) is between high and low in price. This is easily calculated by taking the high price and divide it by the low price, e.g. 12 to 1!
- Another clue can be found as well in a bad or disappointing year of a company and to see how far the price can drop and/or how fast the price can rebound!

Conclusion:
Many financial analysts will find "higher valued" companies more interesting than the lower valued companies, primarily because of their better "market action" and secondarily because of their faster recent growth in earnings.

According to Graham's principles this is not a valid reason for selection - instead its something for speculators! The second point, faster growth, has validity but within limits! Can past growth and presumably good prospects justify a price of more than 60 times its recent earnings? The answer here was maybe, and only if someone has done an in-depth study of possibilities of such a company and come up with exceptionally firm and optimistic conclusions. But not for the careful investor who wants to stay realistic and don't fall for the Wall Street error of overenthusiasm for good performance in earnings and in the stock market!

The seven statistical requirements (quantitative) were only met by two companies of the four and they are as followed:

1. Adequate size
2. A sufficiently strong financial condition
3. Continued dividends for at least the past 20 years
4. No earnings deficit in the past ten years
5. Ten-year growth of at least one-third in per-share earnings
6. Price of stock no more than 1.5 times net asset value
7. Price no more than 1.5 times average earnings of the past three years

In the coming post, we will go into more detail on these requirements!