SECURITY ANALYSIS | PART 2- FINANCIAL STATEMENTS (BY BENJAMIN GRAHAM)

In the last video of this Security Analysis miniseries I made a brief introduction to the topic of analyzing securities in the markets. Among other things, the difference between an investment and speculation was explained, and if you haven't watched that video yet, I highly recommend you do so before watching this one. For this video, we are going to talk about income

statements

and balance sheets. I'll explain why it's important to consider them and what to look for, not as an accountant, but as an investor. If you are not completely familiar with these two

financial

statements

, I suggest you watch this video before continuing here.

Now let's delve into the second

part

of Benjamin Gray Ham's masterpiece. Conclusion number 1: Analysis of the income statement Let's start with the income statements. This reveals a company's historical earnings, which, in turn, is a good indicator of how much investors have received over the same period. The study of this statement is divided into three different sections: The accounting aspect: what are the true benefits of the past? The business aspect: what does the future hold? And on the investment side: based on this indication, what is a reasonable valuation of the

security

? In the previous video, I said that: "Data in company reports may not always present the situation in a way that is useful to the investor." Now, let me present an absurd hypothetical example to show you why.

Imagine that you have the possibility of investing in one of three different YouTubers. Youtuber A, B and C. They produce videos in the same niche. They all have the same income, say $500 a year, that they generate from ads, and they all have 100 shares outstanding. They all bought computers for their businesses 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 decide to depreciate, or in other words, amortize the value of their computers, over five years. C, on the other hand, decides to write off the entire value declared on the balance sheet in just one year.

Two years later she decides that she wants to invest in one of these businesses. At first glance, when looking at the second year's earnings, it may appear that 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 of Company A, perhaps only $2 speculatively, in the hope that profit margins will increase soon. On the other hand, for B and C, he might be willing to pay, for example, ten times annual earnings, or in other words, $25 and $50 per share respectively.

Someone interested in buying the entire business would realize how absurd this is. Actually?? Pay 25 times more for a similar company that generates the same amount of cash? Naaaah... Also, company A has assets worth a total of $2,500, while C has (not really on the books) assets worth $1,750. So there's even an argument for paying more for company A than C. Even if this example is a bit extreme, I hope you get the point. Earnings play an important role in deciding the valuation of companies and yet they sometimes reveal it. little about how the business is actually doing. You need to be able to adjust earnings yourself so that they give a fairer representation of the past, and to do that we need to know some of the common ways companies distort their performance.

And unfortunately, they usually disguise themselves better than in this hypothetical example I just showed. Takeaway #2: Six Common Ways to Misrepresent Earnings When deciding what the true earnings of the past are, we want to understand what Benjamin Graham calls the "earnings power" of the company. This can be considered the ordinary operating profits of the company. But the analyst must remember that even after adjustments he will only obtain a more correct version of the past. The correction of the income statement is carried out through a "negative path" approach, as Nassim points out. Taleb would call him. We eliminate what is wrong and then we get something that is right.

Well, at least it's almost correct. Here are six common ways to confuse investors. Accelerated depreciation. This is how depreciation works in theory: If a capital asset has a limited life, steps must be taken to write off the cost of the asset through charges against earnings, spread over the period of its life. But in practice, companies do not always follow this. Sometimes they decide to write off these assets faster than the useful life of the asset suggests, as YouTuber C did in our conclusion above. This will make profits in the coming years appear larger than they really are.

Beware. Slowed Depreciation At other times, depreciation occurs too slowly. If YouTuber A, for example, had used ten-year straight-line depreciation for his computer, instead of five, it would have looked like he earned $250 more each year. But obviously the earning power of his company would not have been $250 greater, nor would it have been worth more to an investor simply because he used another accounting method. Allocate expenses to the balance sheet instead of the income statement. Sometimes companies "capitalize" normal operating costs, meaning they reduce their expenses on the income statement by moving them to the balance sheet, accumulating long-term assets.

Therefore, income statement profits are increased. The YouTuber finds himself in a very interesting situation here. If you create content that can be consumed over many years, should the expenses associated with making your videos be considered operating expenses or capital expenses? Pretending that EVERYTHING is extraordinary. Extraordinary expenses should generally be eliminated and therefore the numbers increased when calculating the true earning power of a company. But, as you've probably already guessed, some companies are clever about this. Let's say the YouTuber bought some product that didn't do very well. You would have to write down the value of the merchandise on your balance sheet, which will negatively affect profits.

But if he decides to call this expense "extraordinary," the average investor will usually overlook it in his valuation of the business. Record income prematurely. Even if all services under a contract have not yet been fulfilled, all profits may be recorded in the current period. Let's say the YouTuber has a

part

nership with another channel, where he is supposed to create a new series. You get paid when you finish the entire series. At the end of the first year, he could have completed, say, half of the series, but he still decides to record all contractual income in the current year.

Carry over current expenses to the next year... or the year after that. The height of hypocrisy is reached when a company records its profits prematurely, but then takes exactly the opposite stance when it comes to expenses. Let's say a YouTuber wants to create a website for his channel and hires a programmer to do it. Maybe the website is up and running, but there is still a contract in place for updates and maintenance after the first year. The investor will want to see the expenses accrued so far on the income statement, but the books may not show it, since "future services are still available." If you're not sure, always compare it with competitors within the same sector, something we'll talk about in the next video.

And also, when making these adjustments, always remember that: "Security

analysis

is a strictly practical activity, and should not dwell on issues that are unlikely to affect the final judgment." Conclusion number 3: What does this indicate for the future? Alright. So we have answered the first question: what are the true profits of the past? Now, for the second: what does this indicate for the future? Let's consider two different types of hypothetical income records. Which do you think provides better guidance for the future? Obviously, it's A. We said in the last video that the future is no respecter of the past, and this is still true.

But... Past earnings give a rough indication, and you can trust this indication more if: - The earnings record is longer - An average is used - Includes full market cycles - The business is stable Follow-up question: How do you think the profits of these two companies will grow in the next five years? It's really tempting to simply project the past earnings trend into the future. According to Benjamin Graham, you have to be very careful when doing this. The value of the investment can only be related to demonstrated performance. "Competition, regulation, the law of diminishing returns, etc., are powerful enemies of unlimited expansion and, to a lesser extent, opposing elements can operate to check continued decline." Or, in other words, neither abnormally good nor abnormally bad conditions for a company last forever.

In the third and fourth videos we will answer the third question: what is a reasonable valuation of value? Conclusion Number 4: Balance Sheet Analysis We have come to the other important

financial

statement that existed during Benjamin Graham's time as an investor: the balance sheet. Instead of using only income statement profits as the basis for his investment. which, as we have seen, is both fluctuating and the subject of misleading representations, why not use a double test? Going back to conclusion number one, you would surely like to acquire the YouTuber with a more valuable asset, all things being equal.

I mean... in case he decides to stop posting these YouTube videos and leaves the company, you can at least sell his computer on eBay and get some of your money back, which limits the downside. The usual goal of balance sheet

analysis

is to eliminate weak companies. For example, you can identify if the company has: Liquidity problems, by looking at the current ratio and insisting that it is greater than 2. Problems paying interest charges, by looking at the interest coverage ratio (more on this in video number 4, although ). Too much or perhaps too little debt; We will talk more about this in the next chapter.

Or problems with sales, looking at inventory levels and how they have changed over time. Don't overlook the balance! Assets and liabilities may not be as attractive as income and profits, but they are just as important to the smart investor... and more reliable! Takeaway #5: The Importance of Capitalization Structure A central part of the balance sheet is how the company has been financed: often part equity and part liabilities, sometimes issued as bonds. This is known as the "capitalization structure" of a company. Let's go back to the three YouTubers. Neglect their computers, but remember they made $500 a year. Company A is capitalized solely with stock, Company B as a combination of common stock and $2,000 in bonds, at an interest rate of 5%, while Company C has common stock and $6,000 in bonds, also at 5%. %.

After deducting interest expenses from the income of each of these companies, they earn the following amounts per year. Let us again assume that its common shares are valued at a p/e of 10 and therefore the total value of the companies common shares should be as follows. Adding up the value of the bonds to arrive at a total valuation for each company, we noticed something interesting. The total value of company B is $1,000, or 20% more than that of A, and the enterprise value of C is even $3,000 more, or 60%. How can it be that companies with the same earning power can be valued so differently, based solely on capitalization?

Can? To answer this question, we must understand whether it is reasonable to value common stocks at a p/e of 10 and bonds at so-called "face value," in each of these cases. Let's compare Company B to Company A. There is no reason to believe that Company B's bonds would be priced below par. The company earns five times its interest expense, which provides a margin of safety (more on this in the fourth video). Sure, Company B's common shareholders are more vulnerable to reduced earnings than Company A, but this is offset by the leverage they have compared to Company A's shareholders in the event of an increase.

As paradoxical as it may seem, we must accept that company B is worth $6,000, or 20% more than A simply because of its capitalization structure. Benjamin Graham states the following as a general rule: "The optimal capitalization structure for a company includes senior securities to the extent that they can be safely issued and purchased for investment." With company C, on the other hand, we are not convinced regarding the "

security

" and "purchased as an investment" part. A bond, which earns only 1.66 times its interest expenses, is typically not considered safe. According to Graham, the threshold for industrial companies, for example, is 3.

Additionally, the earnings on Company C's common stock are even more leveraged. And therefore, rises and falls in revenue have an even greater effect (in percentage terms) on shareholder profits. WithoutHowever, in this case, the leverage may scare some conservative investors, and this will decrease the demand for the stock and, consequently, also the price and P/E. Therefore, it is safe to say that Company C's value would not total $8,000 and could probably be valued even lower than that of Company A. We conclude by calling Company A's capitalization "overconservative." That of B, “appropriate” or “adequate”, and that of C “speculative”.

It's recap time! The first priority when analyzing an income statement is to understand what the true profits of the past have been. There are many ways earnings can be misrepresented. Knowing these tricks, the intelligent investor can adjust the historical figures to a more correct version. Averages and extensive records make assumptions about future earnings more reliable. Eliminate weak companies through careful study of balance sheets. In fact, some debt can be beneficial to the common stock investor, as the amount invested becomes more productive when a reasonable portion of the capital is borrowed. In the next video, it's finally time to talk about common stocks, and then in the last video of this miniseries, we'll talk about senior stocks.

Health!