THE INTERPRETATION OF FINANCIAL STATEMENTS (BY BENJAMIN GRAHAM)

One day I came across a small brewery: F&M Schaefer Brewing Company. I'll never forget looking at the balance sheet and realizing that the company's book value was $40 million higher than its current market capitalization, with $40 million in intangible assets. I told my colleague, "It looks cheap! It's trading below book value! A classic Benjamin Graham value stock!" My colleague said, "Take a closer look." I looked at the

financial

statements

, but they didn't reveal where these intangible assets came from, so I decided to call Schafer's treasurer and ask him. "Hey, I'm looking at your balance sheet right now and I'm wondering... where does this $40 million in intangibles come from?" "Oh, you don't know our jingle?" That was my first analysis of an intangible asset and of course it was greatly exaggerated.

Let's say I didn't end up buying the company. I wonder how many of today's jingles appear on companies' balance sheets. The success of an investment ultimately depends on future developments, but can never be accurately forecast. However, if you have accurate information about the current situation of a company, you will be better prepared than others to understand the future as well. Understanding, the current situation of a company is strongly related to the correct

interpretation

of its

financial

statements

, and in this video, we will learn how to do it, because this is: a summary of the five main takeaways from The Interpretation of Financial Statements. , by the legendary father of value investing, Benjamin Graham.

Conclusion Number 1: Understanding the Income Statement and Balance Sheet To appreciate the rest of this summary, it is important to know the basics of what an income statement and balance sheet are. However, explaining every element of these two statements wouldn't make a good top five list, so I'll just give a quick introduction here and then we'll move on to the really juicy stuff. The Income Statement The income statement focuses on a company's revenues and expenses over a specific period of time, typically a quarter or a year. The statement starts with income and ends with the company's profits or net income.

Let's see how. First, the costs of the goods are usually subtracted. Other operating expenses, such as salaries, transportation, utilities, and depreciation, are then deducted. We have now calculated operating income or EBIT, which stands for earnings before interest and taxes. If we eliminate interest payments on debt and let the government keep its piece of the pie, and eliminate the "before" because now is the "after", we will end up with net profits or income. The Balance Sheet The balance sheet is a snapshot in time, usually December 31, that visualizes two parts that must always be "balanced": how much a company owns and how much it owes.

What you own is shown on the assets side. What you owe is shown on the liability side. Assets are mainly divided into two categories: long-term assets, such as machinery, real estate, production plans, and intangibles, and current (or short-term) assets, such as cash in the bank, liquid securities, and inventory. The liability side is mainly divided into three parts: long-term liabilities, current liabilities, and stockholders' equity (money that belongs to you as the stock owner). Hope for?? Why is money that belongs to me listed on the liability side? Yes, this is a little confusing, but it should be seen from the company's perspective: shareholders' equity is what the company owes YOU as a shareholder.

Favorably, it could also be seen as the difference between assets and liabilities. Basically... Assets = Liabilities (including stockholders' equity), actually means: Assets - Liabilities = Shareholders' Interest Your local accountant may think this is all technicalities, but it's the most useful way to look at it as an investor. Conclusion number 2: Industry-specific characteristics From these two statements there are many useful indicators that you can calculate. Numbers that will help you in your fundamental analysis of a company. However, these figures often vary from industry to industry. Let's take a look at three commonly used indicators. Net Margin This indicator can be calculated by taking a company's net income and dividing it by revenue.

Basically, it indicates how much money is left for possible reinvestments in the company, or for distribution to shareholders, for each dollar earned in the company (although this is a slight simplification). The net margin depends largely on the specific industry of the stock. For example: a 5% margin would be considered terrible for a healthcare technology company, while it could be a great result for a distribution services company. The current ratio By dividing current assets by current liabilities, we obtain the current ratio. This is an indicator of whether the company will be able to pay its short-term obligations or not.

It is better for the number to be greater than one, especially if the company is struggling to make a profit, or will soon have to sell long-term assets, borrow more money, or ask for more capital from investors. Benjamin Graham suggests that the ratio should be greater than two. But again, this depends on the industry. For example: A construction company might be fine with a number slightly less than one, if it has recurring profits and a small inventory. On the other hand, a manufacturing company with a number less than one could be in a bad position. Especially if your inventory is not liquid.

The P/B Ratio The P/B ratio, or price-to-book ratio, can be calculated by dividing the company's market capitalization by the total value of its balance sheet, which is equal to the sum of the left-hand side or right side Again, VERY dependent on the industry. A money bank may have a huge balance sheet and therefore a low P/B ratio, while a consulting company is in the opposite situation. As we learn from the introductory story, sometimes a company's balance sheet is inflated, and this can cause problems for the stock market investor. Below we will see why.

Conclusion #3: Watered Shares The introduction mentioned the Schaefer jingle and highlighted and questioned the fact that the company had recorded it as an asset on the balance sheet worth $40 million. Stocks like Shaefer are called "watered stocks" because of their tendency to overstate values ​​in financial statements, perhaps especially on the balance sheet. Originally, watering was a method of increasing the weight of cattle before sale. The cattle were tricked into swelling with water before being weighed during the transaction. In the case of stocks traded on these stock markets, this is so common that Benjamin Graham says that little or no importance should be given to the part of balance sheet assets called intangibles. "It is the income statement that reveals the real value of the assets, not the arbitrary figures on the balance sheet." Inflated numbers on the balance sheet can cause problems for the investor in the future, as the company could be forced to write down the value of these inflated assets.

This results in higher depreciations, which negatively affects the company's net income. If a company has a high value of total assets compared to revenue, this could be of great importance to consider, because the larger the assets, the greater the potential negative impact on profits. Takeaway #4: A Company's Liquidation Value Value investing strives to identify stocks that are priced below their intrinsic value, something Benjamin Graham discusses in his The Intelligent Investor (link in description). Intrinsic value is calculated using fundamental analysis, and one method that Ben Graham is famous for in this regard is the book value approach. If a company sold all of its assets today and used them to pay its liabilities, the remaining cash is called book value.

Although quite rare to see in today's market, a stock with a book value that exceeds its current market capitalization is a very interesting opportunity. In such a situation, shareholders have options. The downside of investing in shares is limited, as shareholders may decide to liquidate the entire business. At the same time, there is still enormous potential for improvement if the company manages to improve its business. However, a warning is necessary. As mentioned in the previous conclusion, a company's assets can be watered down. Here are three general rules to keep in mind when investing using the book value approach: - Current assets are usually valued at fairer prices than fixed assets. - The company is in a poor negotiating position in the event of liquidation, so the assets should probably be valued below market value. - The characteristics of the goods must also be considered.

A specialized manufacturing company will probably have more difficulty selling its manufacturing plants than a bank or insurance company will have to sell its financial assets. Conclusion Number 5: Expected Returns of the Quantitative Investor An investor who buys stocks when companies look cheap based on their financial statements (only) and sells them when they look expensive based on the same financial statements will probably not make spectacular returns. On the other hand, the investor will probably avoid large losses. Therefore, my own analysis consists of two steps: first, I filter out companies that appear healthy based on their financial statements and ratios, and second, I filter them based on market trends, competition, scalability, etc.

The first part is quantitative and the second is qualitative. The second part takes much longer, but it's also what can turn an average stock performance into a spectacular one. Famed investor Philip Fisher recommends a similar approach to picking stocks in his book Common Stocks and Uncommon Profits (link in description). That was it for Benjamin Graham's Interpretation of Financial Statements. Know your income statements and balance sheets Ratios are useful when considering the fundamentals of a company, but be careful! Whether the numbers are healthy or not depends on the industry. It is quite common for stocks to be "watered" to make them appear to be performing better than they actually are.

If a stock is priced below its current book value, the savvy investor should take a closer look: this could be a great value investment opportunity. To achieve maximum portfolio returns, the value investor must conduct both quantitative and qualitative analysis of his investments in the stock market. Thanks for watching the full video. Health.