The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [126]
Is a job of this kind worth doing? Our answer is in the affirmative, but our reasons may appear somewhat cynical to the reader. We doubt whether the valuations so reached will prove sufficiently dependable in the case of the typical industrial company, great or small. We shall illustrate the difficulties of this job in our discussion of Aluminum Company of America (ALCOA) in the next chapter. Nonetheless it should be done for such common stocks. Why? First, many security analysts are bound to make current or projected valuations, as part of their daily work. The method we propose should be an improvement on those generally followed today. Secondly, because it should give useful experience and insight to the analysts who practice this method. Thirdly, because work of this kind could produce an invaluable body of recorded experience—as has long been the case in medicine—that may lead to better methods of procedure and a useful knowledge of its possibilities and limitations. The public-utility stocks might well prove an important area in which this approach will show real pragmatic value. Eventually the intelligent analyst will confine himself to those groups in which the future appears reasonably predictable,* or where the margin of safety of past-performance value over current price is so large that he can take his chances on future variations—as he does in selecting well-secured senior securities.
In subsequent chapters we shall supply concrete examples of the application of analytical techniques. But they will only be illustrations. If the reader finds the subject interesting he should pursue it systematically and thoroughly before he considers himself qualified to pass a final buy-or-sell judgment of his own on a security issue.
Commentary on Chapter 11
“Would you tell me, please, which way I ought to go from here?”
“That depends a good deal on where you want to get to,” said the Cat.
—Lewis Carroll, Alice’s Adventures in Wonderland
Putting a Price on the Future
Which factors determine how much you should be willing to pay for a stock? What makes one company worth 10 times earnings and another worth 20 times? How can you be reasonably sure that you are not overpaying for an apparently rosy future that turns out to be a murky nightmare?
Graham feels that five elements are decisive.1 He summarizes them as:
the company’s “general long-term prospects”
the quality of its management
its financial strength and capital structure
its dividend record
and its current dividend rate.
Let’s look at these factors in the light of today’s market.
The long-term prospects. Nowadays, the intelligent investor should begin by downloading at least five years’ worth of annual reports (Form 10-K) from the company’s website or from the EDGAR database at www.sec.gov.2 Then comb through the financial statements, gathering evidence to help you answer two overriding questions. What makes this company grow? Where do (and where will) its profits come from? Among the problems to watch for:
The company is a “serial acquirer.” An average of more than two or three acquisitions a year is a sign of potential trouble. After all, if the company itself would rather buy the stock of other businesses than invest in its own, shouldn’t you take the hint and look elsewhere too? And check the company’s track record as an acquirer. Watch out for corporate bulimics—firms that wolf down big acquisitions, only to end up vomiting them back out. Lucent, Mattel, Quaker Oats, and Tyco International are among the companies that have had to disgorge acquisitions at sickening losses. Other firms take chronic write-offs, or accounting charges proving that they overpaid for their past acquisitions. That’s a bad omen for future deal making.3
The company is an OPM addict, borrowing debt or selling