The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [118]
Chapter 11
Security Analysis for the Lay Investor: General Approach
Financial analysis is now a well-established and flourishing profession, or semiprofession. The various societies of analysts that make up the National Federation of Financial Analysts have over 13,000 members, most of whom make their living out of this branch of mental activity. Financial analysts have textbooks, a code of ethics, and a quarterly journal.* They also have their share of unresolved problems. In recent years there has been a tendency to replace the general concept of “security analysis” by that of “financial analysis.” The latter phrase has a broader implication and is better suited to describe the work of most senior analysts on Wall Street. It would be useful to think of security analysis as limiting itself pretty much to the examination and evaluation of stocks and bonds, whereas financial analysis would comprise that work, plus the determination of investment policy (portfolio selection), plus a substantial amount of general economic analysis.1 In this chapter we shall use whatever designation is most applicable, with chief emphasis on the work of the security analyst proper.
The security analyst deals with the past, the present, and the future of any given security issue. He describes the business; he summarizes its operating results and financial position; he sets forth its strong and weak points, its possibilities and risks; he estimates its future earning power under various assumptions, or as a “best guess.” He makes elaborate comparisons of various companies, or of the same company at various times. Finally, he expresses an opinion as to the safety of the issue, if it is a bond or investment-grade preferred stock, or as to its attractiveness as a purchase, if it is a common stock.
In doing all these things the security analyst avails himself of a number of techniques, ranging from the elementary to the most abstruse. He may modify substantially the figures in the company’s annual statements, even though they bear the sacred imprimatur of the certified public accountant. He is on the lookout particularly for items in these reports that may mean a good deal more or less than they say.
The security analyst develops and applies standards of safety by which we can conclude whether a given bond or preferred stock may be termed sound enough to justify purchase for investment. These standards relate primarily to past average earnings, but they are concerned also with capital structure, working capital, asset values, and other matters.
In dealing with common stocks the security analyst until recently has only rarely applied standards of value as well defined as were his standards of safety for bonds and preferred stocks. Most of the time he contended himself with a summary of past performances, a more or less general forecast of the future—with particular emphasis on the next 12 months—and a rather arbitrary conclusion. The latter was, and still is, often drawn with one eye on the stock ticker or the market charts. In the past few years, however, much attention has been given by practicing analysts to the problem of valuing growth stocks. Many of these have sold at such high prices in relation to past and current earnings that those recommending them have felt a special obligation to justify their purchase by fairly definite projections of expected earnings running fairly far into the future. Certain mathematical techniques of a rather sophisticated sort have perforce been invoked to support the valuations arrived at.
We shall deal with these techniques, in foreshortened form, a little later. However, we must point out a troublesome paradox here, which is that the mathematical valuations have become most prevalent precisely in those areas where one might consider