Unanswered Questions

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An age-old difficulty for investors is ascertaining the value of future growth. In the preface to the first edition of Security Analysis, the authors said as much, "Some matters of vital significance, eg., the determination of the future prospects of an enterprise, have received little space, because little of definite value can be said on the subject."

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Clearly, a company that will earn $1 per share today and $2 per share in 5 years is worth considerably more than a company with identical current per share earnings and no growth. This is especially true if the growth of the first company is likely to continue and is not subject to great variability.
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Another complication is that companies can grow in many different ways - for eg. selling the same number of units at higher prices; selling more units at the same (oe even lower) prices; changing the product mix, or developing an entirely new product line. Obviously, some forms of growth are worth more than others.

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There is a significant downside to paying up for growth or, worse, to obsessing over it. Graham and Dodd astutely observed that "analysis is concerned primarily with values which are supported by facts and not with those which depend largely upon expectations."

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Strongly preferring the actual to the possible, they regarded the "future as a hazard which his conclusions must encounter rather than as the source of his vindication."

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Investor should be especially vigilant against focusing on growth to the exclusion of all else, including the risk of overpaying. Again, Graham and Dodd were spot on, warning that "carried to its logical extreme, . . . [there is no price] too high for a good stock, and that such an issue was equally 'safe' after it had advanced to 200 as it has been at 25."

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Precisely this mistake was made when stock prices surged skyward during the Nifty Fifty era of the early 1970s and the dot-com bubble of 1999 to 2000.

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The flaw in such a growth-at any-price approach becomes obvious when the anticipated growth fails to materialize. When the future disappoints, what should investor do ? Hope growth resumes ? Or give up and sell ? Indeed failed growth stocks are often so aggresively dumped by disappointed holders that their price falls to levels at which value investors, who stubbornly pay little or nothing for growth characteristics, become major holders.

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Wisdom of Continuing the Business should be Considered

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The question, viz., that of retaining the stockholders's capital in the business, involves considerations that are basically identical. Managements are naturally loath to return any part of the capital to its owners, eventhough this capital may be far more useful - and therefore valuable - outside of the business than in it. Returning a portion of the capital (eg., excess cash holdings) means curtailing the resources of the enterprise, perhaps creating financial problems later on and certainly reducing somewhat the prestige of the officers.

Complete liquidation means the loss of the job itself. It is scarcely to be expected, therefore, that the paid officers will considered the questions of continuing or winding up the business from the standpoint solely of what is the best interests of the owners. We must emphasize again that the directors are often so closely allied with the officers - who are themselves members of the board - that they too cannot be counted upon to consider such problems purely from the stockholders' point of view.

Thus it appears that the question whether or not a business should be continued is one that at times may deserve indepedent thought by its proprietors ~ the stockholders.

(It should be pointed out also that this is, by its formal or legal nature, an ownership problem and not a managemet problem.)
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Implications of Liquidating Value

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Wall Street holds that liquidating value is of slight importance because the typical company has no intention of liquidating.

This view is logical, as far as it goes. When applied to a stock selling below break-up value, the Wall Street view may be amplified into the following :

"Although this stock would liquidate for more than its market price, it is not worth buying because :
1. the company cannot earn a satisfactory profit, and
2. it is not going to liquidate.

In the previous post suggested that the first assumption is likely to be wrong in a number of instances, for, although past earnings may have been disappointing, there is always a chance that through external or internal changes the concern may again earn a reasonable amount on its capital.

But in a considerable proportion of cases the pessimism of the market will at least appear to be justified.

We are led, therefore, to ask the question :
"Why is it that no matter how poor a corporation's prospect may seem, its owners permit it to remain in business until its resources are exhausted? "
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Discrimination Required in Selecting "Stocks selling below Liquidating Value"

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There is scarcely any doubt that common stocks selling well below liquidating value represent on the whole a class of undervalued securities. They have declined in price more severely than the actual conditions justify. This must mean that on the whole these stocks afford profitable opportunities for purchase.

Nevertheless, the securities analyst should exercise as much discrimination as possible in the choice of issues falling within this category. He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments listed in "previous post."

Or else he will be partial to such as reveal other attractive statistical features besides their liquid-asset position, eg., satisfactory current earnings and dividends or a high average earning power in the past.

The analyst will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing to do so.

Attractiveness of Stocks selling below Liquidating Value

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Common stocks in this category practically always have an unsatisfactory trend of earnings. If the profits had been increasing steadily, it is obvious that the shares would not sell at so low a price.

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The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid. It may not be denied that this does actually happen in individual cases.

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On the other hand, there is a much wider range of potential developments which may result in establishing a higher market price. These include the following:

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1. The creation of an earning power commensurate with the company's assets. This may result from :

a) General improvement in the industry.

b) Favorable change in the company's operating policies, with or without a change in management. These changes include more efficient methods, new products, abandonment of umprofitable lines, etc.

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2. A sale or merger, because some other concern is able to utilize the resources to better advantage and hence can pay at least liquidating value for assets.

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3. Complete or partial liquidation.

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Financial Reasoning vs Business Reasoning

We have here the point that brings home strikingly perhaps than any other the widened rift between financial thought and ordinary business thought. It is an almost unbelievable fact that Wall Street never asks, "How much is the business is selling for ?" Yet this should be the first question in considering a stock purchase.

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If a business man were offered a 5% interest in some concern for $10,000, his first mental process would be to multiply the asked priceby 20 and thus establish a proposed value of $200,000 for the entire undertaking. The rest of his calculation would turn about the question whether or not the business was a "good buy" at $200,000.

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This elementary and indispensable approach has been practically abandoned by those who purchase stocks.

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Recomendation.

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These examples, extreme as they are, suggest rather forcibly that the book value deserves at least a fleeting glance by the public before it buys or sells shares in a business undertaking. In any particular case the message that the book value conveys may well prove to be inconsequential and unworthy of attention.

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But this testimony should be examined before it is rejected. Let the stock buyer, if he lay any claim to intelligence, at least be able to tell himself, first, what value he is actually setting on the business and, second, what he is actually getting for his money in terms of tangible resources.

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Practical Significance of Book Value

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The book value of a common stock was originally the most important element in its financial exhibit. It was supposed to show "the value" of the shares in the same way as a merchant's balance sheet shows him the value of his business. This idea has almost completely disappeared from the financial horizon. The value of a company's assets as carried in its balance sheet has lost practically all its significance.

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This change arose from the fact,

~first, that the value of the fixed assets, as stated,

frequently bore no relationship to the actual cost and,

~secondly that in an even larger proportion of cases

these values bore no relationship to the figure at which they would be sold

or the figure which would be justified by the earnings.

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The practice of inflating the book value of the fixed property is giving way to the opposite artifice of cutting it down to nothing in order to avoid depreciation charges, but both have the same consequence of depriving the book-value figures of any real significance.

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It is a bit strange, like quaint survival from the past, that the leading statistical services still maintain the old procedure of calculating the book value per share of common stock from many, perhaps most, balance sheets that they publish.

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Before we discard completely this time-honored conception of book value, let us ask if it may ever have practical significance for the analyst. In the ordinary case, probably not. But what of the extraordinary or extreme case ?

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Intro Balance Sheet Analysis ~ Bruce Greenwald

The enduring value of Security Analysis rests on certain critical ideas that were then, and remain, fundamental to any well-conceived investment strategy. The first of these is the distintion between "investment" and "speculation" as defined by Graham and Dodd :

An investment operation is one which, upon thorough analysis,
promises safety of principal and a satisfactory return.
Operations not meeting these requirements are speculative.

The critical parts of this definition are "thorough analysis" and "safety of principal and a satisfactory return." Nothing about these requirements has changed since 1934.

A second related idea is that of focusing on the intrinsic of a security. It is according to Graham and Dodd,

that value which is justified by the facts,
eg., the assets, earnings, dividends, [and] definite prospects,
as distinct, let us say, from market quotations
established by market manipulation or distorted by psychological excesses.
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Other requisites for common stocks of Investment Grade and a Corollary Therefrom

It should be pointed that if 20 times average earnings is taken as the upper limit of price for an investment purchase, then ordinarily the price paid should be substantially less than this maximum. This suggests that about 12 times earnings may be suitable for the typical case of a company with "neutral" prospects.

We must emphasis also that a reasonable ratio of market price to average earnings is "NOT the ONLY" requisite for a common stock investment. The company must be satisfactory also in its "financial set-up and management," and not unsastifactory in "its prospects."

From this principle there follows another important corollary, viz.: "An attractive Investment is An Attractive Speculation." This is true because, if a common stock can meet the demand of "conservative" investor that he get full value for his money 'plus' not unsatisfactory future prospects, then such an issue must also have a fair chance of appreciating in market value.
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A suggested basis of "Maximum Appraisal" for Investment

The investor in common stocks, equally with the speculator, is dependent on future than past earnings. His fundamental basis of appraisal must be an intelligent and conservative "estimate" of the future earning power.

But his "measure" of future earnings can be conservative only if it is limited by "actual performances over a period of time." And in most instances he will derive the investment value of a common stock from the "average earnings of a period between 5 and 10 years."

This does not mean that all all common stocks with the same average earnings should have the same value.
The common-stock investor (@ the conservative buyer) will properly accord a "more liberal valuation" to those issues
> which have current earnings above the average or
> which may reasonably be considered to possess better than average prospects
> or possess an inherently stable earning power.

But it is essential that some moderate upper limit must "in every case" be placed on the multiplier in order to stay within the bounds of conservative valuation, suggested that "about 20 times average earnings" is as high a price as can be paid in an "investment" purchase of a common stock.

Limited Functions of Analyst in Field of Appraisal of Stock Prices

Confronted by the mixture of changing facts and fluctuating human fancies, the securities analyst is clearly incapable of passing judgement on common-stock prices "generally."

There are , however, some concrete, if limited, functions that he "may" carry on in this field, of which the following are representative :

1. He may set up a basis for "conservative or investment" valuation of common stocks, as distinguished from speculative valuations.

2. He may point out the significance of :
(a) the capitalization structure; and
(b) the source of income
as bearing upon the valuation of a given stock issue.

3. He may find unusual elements in the balance sheet which affect the implications of the earnings picture.
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Exact Appraisal Impossible

Security analysis cannot presume to lay down general rules as to the "proper value" of any given common stock. Practically speaking, there is no such thing. The bases of value are too shifting to admit of any formulation that could claim to be even reasonably accurate. The whole idea of basing the value upon "current earnings" seems inherently absurd, since we know that the current earnings are constantly changing. And whether the multiplier should be 10 or 15 or 30 would seem at bottom a matter of purely arbitrary choice.

But the stock market itself has no time for such scientific scruples. It must make its values first and find its reason afterwards. Its position is much like that of a jury in a breach-of-promise suit; there is no way of measuring the values involved, and yet they must be measured somehow and a verdict rendered.

Hence the prices of common stocks are "not carefully thought out computations" but "the resultant of a welter of human reactions."

The stock market is a voting machine rather than a weighing machine.
It responds to factual data "not directly" but only as they "affect the decisions" of buyers and sellers.
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